Investing in Central and Eastern Europe

Central and Eastern Europe is a collection of culturally diverse countries many of which are experiencing strong economic growth. What all have in common is emergence from communist regimes and the straightjacket of central planning. The economic landscape of the region has changed beyond recognition in the last fifteen years, and globalisation, accession into the European Union (or for some, the promise of it) and commercial market forces have driven growth across the region. Many businesses, large and small, choose to set up operations in Central and Eastern Europe, attracted by lower start-up costs and high quality, relatively low-cost workforces. For those CEE countries such as Poland and the Czech Republic that are already members of the EU, many of the procedural hurdles and regulatory issues now mirror those across Europe, and businesses and individuals alike can benefit from the effects of pan-European legal harmonisation. However, although progress to date in making CEE countries more attractive to investors is encouraging, each of these countries still has its share of cultural practices and bureaucracy that at times, needs careful handling. This article serves to provide information on the region and highlight key issues and topics that interested investors ought to be aware of.

Economics - forecasts, facts and figures

Current and predicted economic growth in the CEE region far outstrips that of the traditional 12 EU members, demonstrating impressive levels of external investment and productivity. Increasing numbers of large global firms in all industry sectors are setting up operations in, or outsourcing functions to, the region, as well as discovering new markets for their products.



Let’s take a look at some facts and figures relating to the key players in the region:

Romania
Capital: Bucharest
Currency: Leu (ROL)
Accession to the EU: To join in January 2007/08
Population: 22.3 million
Real GDP Growth: 4.5% (2006)
GDP/PPP (2006)
Total: $204.4 billion
Per capita: $8,785



Hungary
Capital: Budapest
Currency: Hungarian Forint (HUF)
Accession to the EU: May 1, 2004
Population: 10 million
Real GDP Growth: 4.2% (2006)
GDP/PPP (2005)
Total: $169,875 million
Per capita: $17,405

Russia
Capital: Moscow
Currency: Russian Ruble (RUR)
Population: 142.8 million
Real GDP Growth: 5.5% (2006)GDP/PPP (2005)
Total: $1.778 trillion
Per capita: $12,254



Czech Republic
Capital: Prague
Currency: Czech Koruna (CZK)
Accession to the EU: May 1, 2004
Population: 10.2 million
Real GDP Growth: 4.1% (2006)
GDP/PPP (2005)
Total: $198.976 billion
Per capita: $19,475



Bulgaria
Capital: Sofia
Currency: Lev (BGL)
Accession to the EU: To join in January 2007/08
Population: 7.4 million
Real GDP Growth: 5.5% (2006)
GDP/PPP (2005)
Total: $62.292 billion
Per Capita: $9,223



Poland
Capital: Warsaw
Currency: Zloty (PLN)
Accession to the EU: May 1, 2004
Population: 38.5 million
Real GDP Growth: 4.3% (2006)
GDP/PPP (2005)
Total: $489.8 billion
Per Capita: $12,700

Handling officials in Central and Eastern Europe

Government institutions and regulatory bodies often determine how easy it is for foreign investors to establish operations or for new players to enter local markets. Generally, the mentality of bureaucratic organisations is changing for the better as governments and public bodies develop a more commercial and flexible approach to their work and implement concepts such as transparency and accountability. Nevertheless there is still room for significant improvement, as outdated and inefficient working methods can cause delays. Ministries and regulators are usually heavily staffed, and their employees are often poorly paid in comparison to the businessmen and lawyers who they deal with. There is usually little movement from the private sector to the state sector, and thus an insight into business and commercial realities is often lacking. The structure of public bodies is often very rigid and hierarchical, and officials may be reluctant to make decisions without the approval of their boss, and this makes identifying and contacting the right people within any organisation particularly important.

Although a deal may be worth millions of pounds and have a global impact, it is local knowledge that can help to move things along; it often helps to visit regulators prior to closing a deal and it is wise to show deference and refer to individuals by their correct titles. Also, one cannot assume that officials will speak much English, so the use of locally qualified lawyers, preferably with experience of dealing with the relevant people, is advisable.

As this table demonstrates, the quality of bureaucracy is generally lower in Central and Eastern Europe than in well developed western economies, such as the UK or the USA (source: Economist Intelligence Group). A rating of 5 represents excellent bureaucracy, while 0 represents a worst-case scenario.

Corruption

Central and Eastern Europe still has a reputation for corrupt practices, and while corruption is certainly less acceptable than it was, it has not been eradicated. In many countries, corruption is endemic in schools and hospitals and amongst junior bureaucrats e.g. planning officials. It is difficult to get a precise feel for the extent of the problem, because by its very nature it is usually kept secret. However, corrupt officials are unlikely to be encountered when handling a typical M&A transaction.  Some countries (e.g. Poland) are making determined efforts to reduce corruption, although perversely this means that some officials are unwilling to meet investors and advisers as they are worried about allegations of corruption.

The 2005 Transparency International Corruption Perceptions Index defines corruption as the abuse of public office for private gain, and measures the degree to which corruption is perceived to exist among a country’s public officials and politicians. The scores range from ten (corruption-free) to zero (corrupt).

Economic Freedom

The concept of economic freedom encapsulates many factors that contribute to making a country an easy or difficult place to do business in. The index of economic freedom, as published by the Wall Street Journal, includes factors of economic freedom such as government intervention in the economy, regulation, rule of law and barriers to trade. The higher a country’s score, the less economic freedom there is, and the scale runs from zero to five.

Quality of legislation in CEE

The quality of legislation in most Central and Eastern European countries has improved dramatically over recent years, particularly as a result of the implementation of EU Directives into national law. Sometimes the work of governmental draftsmen is frustrated by amendments introduced by the parliamentary process. Legislation can, when taken at face value, often be ambiguous and it can help to be aware of jurisprudence and previous interpretations of the law in any given country. Civil servants often tend to a conservative interpretation, so it is often helpful to steer them towards a more constructive approach. Large swathes of EU Directives have been imported into national law, and this has improved drafting, although sometimes local draftsmen have worked from poor quality translations of Directives. In the case of new EU members, investors can rely on the certainty of the acquis communautaire (body of EU Law). Possibly inspired by their new membership, new member states often implement Directives into national law much more quickly than the “old EU”.

Regulatory approvals required in M&A transactions

Merger control clearance will need to be considered whenever one entity acquires another, and where clearance is required, the amount of time that it will take to obtain this will depend on the particular jurisdiction and the size and complexity of the deal. There are likely to be certain approvals required which are peculiar to the locality, for example in Poland investors from non-EEA countries require permits for purchasing real property in Poland. Acquisitions in regulated sectors will normally require separate approvals from supervising authorities (e.g. financial services, media) as will acquisitions in areas of strategic importance (e.g. seaports, airports).

Competition authorities

Across CEE a dual regime operates in the merger control system: European and national. For all EU Member States a “one-stop-shop” principle applies whereby if a transaction has a European dimension the case will be examined by Brussels, and the national regime will not apply. In the absence of a European dimension and for CEE countries outside the EU, national competition rules apply, which usually operate on the same principle as the EU legislation, albeit with different thresholds. While the EU Commission tends to be more meticulous, it is also usually faster than national competition authorities. National authorities can often require large quantities of information, even if some of it seems unnecessary for an assessment of the particular transaction. Thankfully, however, refusals to clear transactions are not frequent in CEE.

State aid

EU law prohibits unauthorised state aid, and as a result the provision of state aid is therefore subject to regulation by the European Commission. Similar rules apply in accession states in relation to state aid, and where unlawful state aid occurs it must be cancelled and/or repaid. CEE transactions often involve acquisitions of companies which have previously received some form of state aid, and there can also be issues as to the provision of aid in the context of privatisations. State aid risk must therefore be actively managed. State aid can take many forms: low interest loans; guarantees; tax breaks and capital injections. Any due diligence process must identify previous aids and establish if they have or need approval. EU law takes a particular interest in privatisations and is often chiefly concerned with whether a privatisation process is open and competitive, and whether any previous aid would pass on to a new purchaser.

Financial sector regulation

The financial sector is rapidly evolving, with increasingly sophisticated products appearing across jurisdictions. At the same time financial services regulation has grown in scope and depth and the industry is subject to more stringent regulation than ever before, including restrictive secrecy rules. Financial services regulators are often perceived as bureaucratic, and there is a trend towards the creation of super-regulators covering banking, insurance and the securities markets. However despite the level of regulation, the industry is thriving in Central and Eastern Europe. A large amount of consolidation in the sector has contributed to the recent increased financial services deal flow in CEE. EU accession means opportunities for FS entities to open branches or use the “passport” system which enables service providers to offer products on a freedom of services basis and thereby bypass local regulation.

Data protection in CEE

Data protection is an increasingly important, demanding and often underestimated area of the law that needs to be considered when undertaking corporate acquisitions in Central and Eastern Europe. The regulatory framework is underpinned by EU Directives governing data protection in the EU. However, existing national legislation is often even more stringent, so country-specific advice is strongly recommended. Specific secrecy rules govern certain areas of business in CEE countries (Insurance, Banking, Labour and Telecommunications). Sanctions for data protection offences are severe; they can be civil, administrative or criminal, including fines and imprisonment for up to two years. Two main levels of regulation apply, depending on whether the entity in question is a data processor, which merely processes data for others, or a data controller, which decides how the personal data will be processed. Under EU law one must have legal grounds for processing personal data, the most common of which is having obtained the data subject’s consent. Furthermore, the law restricts the nature of personal data that can be stored, and data cannot usually be forwarded to third parties without specific consent. There are also further restrictions on transferring data beyond the European Economic Area (the EU plus Norway, Iceland and Liechtenstein). Difficulties can arise because regulations can be imprecise and legislation applied widely. Supervisory bodies often do not communicate well with companies or organisations that seek clarification. There are also few court-established precedents. Occasionally EU and national laws conflict, so it may be necessary to work closely with regulatory bodies to ensure the correct procedure is followed.

Conclusion

More and more international investors are looking to expand their operations into Central and Eastern Europe to take advantage of lower establishment costs, an available skilled workforce, and to sell their products in potentially lucrative new markets. The governmental, legal and commercial frameworks of these countries are evolving to keep up with the changing business environment, with differing levels of success. With the European Union acting as a unifying force and foreign investment recognised as a key driver of these economies, setting up operations in Central and Eastern Europe is becoming more straightforward and attractive.