In recent years there have been endless discussions between Europeans serving in the offices of national governments and those serving in Brussels at the EU headquarters about rising national protectionism in cross-border M&A activities. The situation reached a climax in 2006 when France blocked Enel's (of Italy) attempt to take over the national energy company Suez, Spain blocked EON's bid for Endesa, Poland blocked the merger of UniCredit and HypoVereinsbank. Protectionist culture continued at a national level. More recent examples are Germany's battle at the European Court of Justice over its golden share in Volkswagen, and the rising threat of sovereign funds with Sweden's concern about Bourse Dubai bidding for Scandinavian stock exchange operator OMX. States have been increasingly active in the takeover market, regulating (limiting) access to strategic sectors such as energy and utilities, telecoms, financial services, infrastructure, transport or food industry.

The Baltic states, though having smaller companies in terms of market capitalisation, have been concerned with similar cases. Where the Western European countries raised concerns about investment by sovereign wealth funds originating from the Persian Gulf region countries, the Baltic states were more worried about rising Russian monopolies. These can easily swallow national energy companies in the region without making profit, but for politics-driven investment decisions. Exposure to political risks due to rising activity of Russian companies has made the Baltic states more attentive when making privatisation tenders or accepting investors in state-owned companies. The doors will be left open for investors, but governments will be more cautious than before.

Lithuania's national energy

This year has brought consolidation of the energy sector in Lithuania. The state-controlled electricity transmission company Lietuvos energija and distribution company Rytu skirstomieji tinklai will join forces with another distribution company VST, previously privatised and currently controlled by a private investor (NDX energija). These three companies with aggregate market capitalisation of over €2.2 billion ($3.4 billion) are being consolidated by forming a mutual holding company LEO LT (Lithuanian Electricity Organisation), with the state owning 62% and leaving private investors (the majority shareholders of VST) with 38%. The consolidation into LEO LT was driven by the need to raise funds for developing a new nuclear power plant and power bridges to Poland and Sweden.

There was no public tender for potential investors to joint forces with the state in national energy. Instead it was decided to consolidate transmission companies with a distribution company. Whoever owned them received a stake in the holding company. Thus, the former majority shareholder of VST, NDX energija, received 32% of shares and votes in LEO LT for its majority stake in VST. The merger was structured like the formation of a new company (LEO LT). Experts (KPMG and HSBC) evaluated the shares of Lietuvos energija, Rytu skirstomieji tinklai and VST. Shareholders will transfer shares as a non-monetary contribution into LEO LT share capital and will receive shares in LEO LT in return.

A joint venture with a cash contribution might have been more transparent, as business valuations often lead to debate. However, the state had good reasons to choose the way it did – it wanted to consolidate the electricity sector into a state-controlled company rather than making general tender for a cash-contributing joint venture partner.

At the same time, the state avoided lengthy discussions about the tender procedure to avoid bids from Russian companies. This was a political decision to reduce energy dependence on Russia. The majority shareholder of VST (NDX energija – a company of Lithuanian investors) was an acceptable partner for the state.

Restricted access

The state consolidated its position as a majority shareholder in LEO LT. Under two special laws passed by the Lithuanian parliament the state must own more than half of all shares issued and votes in the shareholders' meeting of LEO LT. The remainder of LEO LT stake may be owned by national, EU, NATO and OECD-origin capital. LEO LT on its part must hold at least two-thirds of all shares issued and votes in shareholders' meetings of Lietuvos energija, Rytu skirstomieji tinklai and VST. Through this pyramid structure (state-one-half majority in LEO LT – two-thirds majority in electricity transmission and distribution companies) the state retains full control of the energy sector.

At the same time, the state included certain safeguards to lock in the private investor in LEO LT and regulate transfer of shares. There is a general statement in the special laws and articles of association of LEO LT that the minority stake may be held by national, EU, NATO and OECD-origin capital.

But it is extremely difficult to control the origin of the capital especially considering globalisation trends. Will a company incorporated by investors from Asia, registered in Cyprus or Luxembourg, be considered an investor of EU origin capital? The answer is probably yes, if you refer to the case law of the European Court of Justice (in Centros, Überseering, and Inspire Art) and case law of ICSID (Tokios tokeles v Ukraine). But the answer is probably no, if you refer to what the state meant by establishing such restrictions on capital origin. Therefore the state regulates (restricts) access to the companies by private laws and shareholders agreements.

Locked in

That was the case with the analysed example, LEO LT. Under the shareholders' agreement the private investor into LEO LT (NDX energija) must retain one-third of all shares and votes in the shareholders' meeting of LEO LT. After the two-year lock-up period NDX energija will be entitled to transfer the shares but will have to retain a stake of more than 5% of all shares and votes. The rationale behind this provision is that the state together with NDX energija would retain two-thirds of all shares and votes in LEO LT. Where NDX energija seeks to transfer the shares below the threshold of 5%, the state will have pre-emption rights to acquire these shares.

The state also has a right to exercise a call option and acquire the 5% block of shares of LEO LT from NDX energija if it is necessary for national security interests or energy security interest or on change of control, liquidation or bankruptcy in NDX energija. In this manner the state will retain control over two-thirds of shares and votes in LEO LT.

Thus the state regulates the controlling stake in this national energy leviathan both through statutory laws and private instruments-shareholders' agreement and articles of association.

All this regulation of shares acquisition may recall the golden shares cases in the European Court of Justice where the Luxembourg court on numerous occasions found it illegal for the states to have special rights to block cross-border takeovers of national companies (the last one of the series of such cases ended in the order by the European Court of Justice for Germany to give up its golden share in Volkswagen).

At the same time the LEO LT case is somewhat different. The state does not attach by law any disproportionate rights to the shares held in LEO LT. Nor has it any statutory rights to block acquisition of shares from NDX energija. The law establishes that the state must retain more than 51% of votes and shares. Accordingly the state invests in the shares and receives the same rights as any other shareholder holding such shares and then simply does not sell the shares to anybody. Regarding shares of NDX energija, the state is not entitled to block any dealings.

According to the agreement it stipulated that the minority shareholder would be locked-in for a period of time and the state may exercise pre-emption and call option rights. This is the customary practice for shareholders' agreements even between private parties (where the state is not involved) enabling the shareholders to control who will be their business partners.

Reducing Russian influence

The case with LEO LT is not the only example. Last year the state took an active part in acquiring a big oil refinery Mazeikiu nafta. Mazeikiu nafta was controlled jointly by Yukos (54% stake) and the Lithuanian government (41% stake). The state had pre-emption rights to acquire the shares held by Yukos, under the shareholders' agreement. This was a strong tool for the state when the time came for Yukos to sell its stake. The state took an active role in selecting bidders for the shares, since otherwise it could acquire the shares itself.

Again a special law was passed obliging the state to retain a 10% stake in Mazeikiu nafta. The state was further aiming to reduce energy dependence on Russia, so Russian bidders were not favoured. The situation was tense since it was in the interest of Yukos to get the highest price possible, while the state sought to get a bidder outside Russian oil companies. However the deal was resolved without deadlock, as the Polish oil company PKN Orlen submitted the highest bid and acquired an 85% stake in Mazeikiu nafta for over $2.3 billion. The state retained a 10% stake and revealed that under the shareholders' agreement it had a pre-emption right to acquire shares and possibly a call option in the case of change of control in PKN Orlen.

These cases are not the only two examples in Lithuania. Discussions have begun about letting private investors into the postal services, railways, maritime, airport and seaport operator companies – still fully-owned by the state. At the same time the recent examples show that the state will have a more active role and be more cautious than before. It is probable that the state will retain majority or at least minority stakes in the indicated companies, actively regulating sale of shares through the instruments in shareholders' agreements.

Estonian Railways

Since gaining independence in the beginning of nineties, Estonia has privatised most state-owned companies and the state is currently a shareholder in main strategic companies such as Estonian Energy, Estonian Railways, Tallinn Airport and the Port of Tallinn. In addition, certain private companies have been formed to simplify the management of state property, such as the State Forest Management Centre, State's Real Estate Company.

Estonian Railways, the national railroad company, was privatised in 2001 when 66% of shares were sold in the course of the privatisation process to Baltic Rail Services (BRS). The state maintained a minority shareholding in the company and had control over the main strategic decisions of the company. BRS' and the state's relations worsened after the privatisation and the parties were not able to agree upon certain issues concerning the management of Estonian Railways. BRS and the state accused each other of breaching the privatisation agreement and submitted disputes to arbitration courts.

In 2006 BRS started the process of selling its shareholding in Estonian Railways to other investors and began negotiations with interested parties. It was speculated that Russian investors were interested. Due to complicated relations on the shareholders' level in the company (the new shareholder would have acquired a majority shareholding in Estonian Railways but would have still required minority shareholders' approval for strategic developments) and probably also because of the state's concern for national security, it was resolved by the government of Estonia to terminate the privatisation agreement with BRS and buy back the majority shareholding in the company for Ekr2.35 billion Estonian (about $234 million). The transaction was closed in the beginning of 2007.

Termination of privatisation agreements and buy-back of privatised companies by the state are unique and exceptional in Estonia. On the other hand, Estonian Railways was and clearly is one of strategic companies for the state due to transit activities in Estonia. It may be possible that buy-back of privatised strategic companies was carried out to prevent unwanted investors controlling railroad monopolies in Estonia.

In 2008 the Estonian government and leading Estonian parties have started public discussions concerning state-owned companies going public. Estonian state-owned companies that may in the near future go public are leading enterprises in the Baltics, including potentially Estonian Energy, Estonian Post, Port of Tallinn, Estonian Railways, Estonian Lotto, and Tallinn Airport. Based on results of Gallup polls of the Tallinn Stock Exchange, it seems that currently about 35% of Estonians support public offering of shares of state-owned companies.

Even though the exact conditions and terms of state-owned companies going public have not yet been proposed by the government and no final decision has been made concerning public offerings of state-owned companies' shares, it is most probable that the state will maintain controlling shareholdings in strategic enterprises and will offer to the public only minority shareholdings of such companies. It should be clear that the state is not willing to make the same mistake it made with privatisation of Estonian Railways.

Most of the state-owned companies that may potentially go public (including Estonian Energy and Estonian Lotto) enjoy monopoly status at the moment and may thus be an interesting investment possibility for investors. However, due to the opening of relevant EU markets, it is unclear what will happen with the market shares and revenues of these state-owned companies in the future. Thus, there are certainly some unclear aspects and risks for potential investors. In addition, there is a risk that state-owned companies are sometimes used as political tools (for example, control over energy prices is offered to customers by Estonian Energy) and this may not be in the interests of potential investors.

Latvia swaps shares

During the past year-and-a-half perhaps the most publicly debated proposed transaction has been the privatisation of 51% of the state-owned shares in fixed-voice telephony operator Lattelecom, and 28% shares in one of the two primary mobile telephony operators LMT (Latvijas Mobilais Telefons).

The current shareholding is as follows: Lattelecom is jointly controlled by the state holding 51% of the shares and Scandinavian operator TeliaSonera holding the remaining 49% of the shares. Meanwhile, the state owns 28% in LMT with the rest of the shares being owned by Lattelecom (23%) and TeliaSonera (49%). In the beginning of 2007 the management of Lattelecom along with global private equity fund Blackstone proposed an MBO of Lattelecom to acquire 100% of the shares. Such a proposal was conceptually approved by the government of Latvia and TeliaSonera, although the latter accepted the proposal on the condition of acquiring the remaining shares in LMT from the state and Lattelecom.

After a period of negotiations with mixed results and the appointment of a new government, the government in the beginning of 2008 rejected the proposed MBO plan. The government also rejected a proposal from TeliaSonera to acquire 100% shares in both Lattelecom and LMT. Some months later the government proposed its own privatisation plan whereby the state would swap its shares in LMT for the shares in Lattelecom with TeliaSonera and would immediately afterwards sell the acquired 49% shares in Lattelecom to a strategic investor, most likely Blackstone. In this scenario the state would retain the 51% shares in Lattelecom for several years. The government has however stated that its ultimate goal is to privatise the remaining 51% shares at its disposal after the share swap deal with TeliaSonera.

The past and the future

During the past 18 years of independence from the Soviet Union, the majority of state-owned companies in Latvia have been privatised. The state has however retained partial or full ownership in companies in several strategic sectors, including railroad (Latvijas Dzelzcels), electricity (Latvenergo), heat (Rigas Siltums), airport (Rigas lidosta), and others. There have been attempts to privatise some of these companies but they have seen limited success. One such proposed transaction that did not materialise was the offer by utilities company Dalkia to purchase 49% of shares in Rigas Siltums from the state in 2007. After initial signs of interest, the state resolved not to go forward with the transaction.

Concluding this short survey, it is clear than in the near future we will see several interesting acquisitions in Baltic states, where the state will let the private investors into promising businesses, such as infrastructure (a sector that remains interesting even in the current market turmoil), postal services, railways, energy, utilities and telecoms companies.

At the same time we will see the state playing a more active role than ever in the sale procedures, carefully picking up bidders, not only for the generosity of their offers, but also for their other merits, such as origin of capital.

Furthermore the Baltic states have learnt lessons from golden share cases and will not pass laws, for example, granting the state powers to block bids. The states will act in the same manner as other private shareholders, retaining minority or majority stakes and exercising their rights through shareholders' agreements: holding pre-emption or first refusal rights, call options, agreeing on management nomination and voting in shareholders' meetings and similar instruments.

Author biographies

Zilvinas Zinkevicius Lideika, Petrauskas, Valiunas ir partneriai Lawin Zilvinas Zinkevicius is a partner at the law firm Lideika, Petrauskas, Valiunas ir partneriai Lawin. He is the head of the corporate and M&A practice group. Zinkevicius graduated with a Master's Degree in Law from Vilnius University in 1993. He obtained an Executive Master of Business Administration (EMBA) degree from the Baltic Management Institute (BMI) in association with Vytautas Magnus University (Lithuania) in 2004. He is national vice president for Lithuania of the Union Internationale des Avocats (UIA), a member of the Disciplinary Committee of the Lithuanian Basketball League (LKL) and a legal expert for Lithuanian Securities Market Development Project by USAID. His main areas of practice are M&A, joint ventures, corporate governance and general corporate advice. Ermo Kosk Lepik & Luhaäär Lawin Ermo Kosk's practice consists of providing legal and corporate advice to foreign companies engaged in business activities in Estonia. His fields of practice are finance and banking, securities and capital markets and corporate law. Kosk has considerable experience in banking and financial law, as a result of advising high profile cross-border transactions in the Baltics. He represents clients in securities transactions and has substantial experience in advising on the implementation of legislation in a wide range of areas in the Estonian economy. His portfolio of clients advised in 2007 include Barclays Bank, Citigroup, Goldman Sachs, HSB Bank Plc, DEPFA, OKO Bank Plc, Bank Austria Creditanstalt AG, Qidnax AB, RCI Bank Polska, Société Générale, Swedbank AB and HSH Nordbank, UBS, Deutche Bank and the Royal Bank of Canada. Kosk also has expertise in M&A and private equity transactions, ranging from large-scale privatisation transactions to complex private equity deals involving leveraged financing and cross-border regulatory issues. Kosk is a regular contributor to finance and securities publications and legal magazines. He is a member of Estonian Bar Association and the Professionals Committee of American Chambers of Commerce in Estonia. Martins Gailis Klavins & Slaidins Lawin Martins Gailis is an associate lawyer and a member of the trade and technology practice group at Klavins & Slaidins Lawin, specialising in competition law, intellectual property law, commercial agency, franchising and distribution. Gailis has an LLM degree with distinction from the Riga Graduate School of Law (2005) and an LLB degree in English and European Law from University of Essex (2004). Gailis has written several law review articles on Latvian antitrust and competition law and practice, and on intellectual property law in Latvia. He speaks English and Latvian.