Introduction

Since the collapse of the Soviet Union in 1991, the three newly independent Baltic countries have made progress in creating viable democracies and free market economies. Although distinct from each other in many respects, the Baltic countries have been affected in similar ways by historical, legal and economic developments.

These countries have all completed their transitions to market economies. Their entry into the EU is the ultimate step in this process, and will signify their abandonment of all remaining socialist legal and economic structures.

During the first few years of transition, with the collapse of existing industrial and trading structures, economic growth was negative in all three countries. But over the past 10 years, the average growth rate in the Baltic region has not only been higher than other transition economies in eastern Europe, but also higher than the average growth rate in the EU. Analysts expect that the Baltic countries will maintain their high GNP growth figures at least for the next few years.

But the Baltic countries are not without problems. The general economic level in each of these countries remains far below the level in EU countries. The average wage level in each country is still much lower than elsewhere in Western Europe. Unemployment is relatively

low but the percentage of employed is considerably lower than, for example, in Finland. Unofficial business activity, where tax laws and other laws are not followed, still seems to exist more commonly than, for example, in the Nordic countries. This relates partly to the transition, which has also led to serious social problems. By Nordic standards, the illegal and legally questionable business activities in the Baltic region remain an issue of concern.

The Baltic countries, particularly Estonia, have actively promoted foreign investment in order to facilitate their transformation from post-Soviet republics to members of the EU. Their legal reforms have removed market entry barriers and discrimination that could inhibit foreign investment. Foreigners are now free to buy real estate or companies in the Baltic region. In general, legal entities in the EU countries have a right to buy companies and real estate in the Baltic states, and are treated equally under the laws in these countries. Some limitations remain relating to foreign ownership of land for agricultural or forestry purposes. The legal and the economic frameworks have been harmonized with western standards.

This harmonization represents an achievement for the Baltic states. Because basic legal concepts such as private ownership and private corporations were not recognized in the former Soviet Union, the Baltic countries, upon achieving independence, were compelled to draft up a completely new set of civil and corporate laws.

These laws were partly based on pre-Soviet laws in force during the period of independence before 1940. Western civil laws and EU legislation affected the law reforms.

The Baltic countries have entered into the necessary international treaties to secure a proper framework for investments. Latvia has concluded agreements on mutual promotion and protection of investments with 36 countries, including the EU states and the US, and agreements regarding double taxation and non-payment of taxes with 25 countries including the US, the UK, Germany, France, The Netherlands, Finland, Sweden, Norway, and Denmark. Estonia and Lithuania have entered into similar treaties. Furthermore, the Baltic states have all concluded free trade agreements with the EU in 1993.

The Baltic countries are also parties to international conventions on the recognition of arbitration awards.

Privatizing state-owned property is the most complex element of the transition to a market economy. It involves distributing national wealth and production capacity ownership from the state to individuals, local companies and foreign investors.

In Estonia, privatization of state-owned property, including enterprises of different sizes and real estate, has been extensive. In fact, the Estonian Privatization Agency has been closed since November 2001. Today private persons own most real estate in Estonia. In Estonia, the German Treuhand international tender model was used when privatizing medium and large enterprises. In contrast to auctions with a focus on the highest fiscal return for the national treasury, the use of the Treuhand method permitted consideration of other interests, such as social and environmental, besides just the price. This method aimed at long-term benefits such as future growth and attracting foreign investment. Even parts of the railways were privatized when Eesti Randtee was sold to a consortium of foreign and local investors. Only a few large enterprises are still owned by the state: Eesti Pölekivi oil and shale mines, Eesti Energia electricity networks, the Port of Tallinn and Narva Power Plants.

In Latvia, the newly independent state's governments have been in favour of privatization. Privatization vouchers issued to Latvians were used widely, and foreign investors were also offered the opportunity to purchase 153 Latvian companies in four international tenders. As in Estonia, most of the large companies in Latvia have been privatized. The Latvian government, however, has not yet decided whether to continue with privatizing the ports, airport, postal services and the national railway company. In the energy industry, after political debate, it was decided to retain state ownership of the Latenergo public energy company and this decision was confirmed by special legislation.

Privatization has also been conducted in Lithuania to a large extent. The first privatization laws were established already in 1991. Under the current legislation, methods of privatization are public sale of shares, public auction, public tender, direct negotiations, transfer of control of state or municipally controlled enterprises, and lease with a right to purchase. In certain circumstances a combination of these methods is possible.

The monetary policy applied by the national Central Banks in the Baltic countries has also been successful. There has been no wide fluctuation in their exchange rates against main currencies, and all three countries have had a relatively low inflation rate. In Estonia, the consolidation of banks has already taken place and six banks operate in this market. They are to a large extent owned by foreign banks. The Latvian market still has 23 banks but the shareholders of the larger banks are Nordic and German banking and financial institutions. Capital repatriation or foreign shareholdings in the banking industry are not significantly limited. Legislation for the financial markets follows EU rules, for example, relating to money laundering.

The incorporation of acquis communautaire has been essential in the transformation process. The Baltic countries have concluded association agreements with the EU and have carried out market protection measures in accordance with western standards. The Latvian competition law was drafted in accordance with EU competition rules on January 1 1998 and in slightly modified form as of January 1 2002. Similar reforms have taken place in Estonia and Lithuania. The telecommunication industry has also been liberalized, even though the Latvian government and TeliaSonera have been engaged in a dispute relating to monopoly rights initially granted until 2013.

Public procurement laws are also in force. In Latvia, the Public Procurement Office has been active in public tenders. In the areas of state aid and public procurement, all directives are transposed, so discrimination against companies from other EU states is not possible.

Tax policies are also designed to promote business activity and attract capital and investment. For example, the Estonian income tax rate for individuals and corporate capital gains is 26%. Additionally, Estonia has a peculiar but investment-promoting corporate tax regime where earnings are principally taxed only when distributed. From January 1 2002, Latvian corporate income tax was reduced from a flat rate of 25% to 22%. The tendency will continue - for 2003 the rate is 19% and it will be 15% in 2004. Latvian personal income tax rate is 25%. The Lithuanian corporate tax rate is 15% (or 13% in certain circumstances). Personal income tax rates are 15% or 33% depending on the nature of income. The employment income rate is 33%.

The legal framework is not only based on statutory laws and regulations but also on the judicial system. Hence, judicial enforcement authorities play a central role. This causes complications because many judges in the Baltic countries were educated during the Soviet period and may also have started their careers during that time.

The Soviet era represented a break in the long-standing legal tradition in the Baltic countries. As a comparison, Finland has applied fundamentally the same civil law since 1734 even though Finland was once a part of Sweden and later became part of Russia. In the Baltic countries, court decisions from the Soviet period, which lasted for more than 50 years, are not useful or reliable as legal precedents, leading to uncertainty in their legal systems.

In order to attain the needed expertise, parties in the Baltic Countries overwhelmingly choose arbitration. In business disputes, arbitration is even more common in the Baltic countries than, for example, in Finland. But the other side of the coin is the lack of an appeal possibility. This feature of arbitration, combined with the general lack of legal tradition, increases the risk for unpleasant surprises. For example, Latvian first instance court decisions might be unjustified, but a party is still able to seek correction of a judgment in the appeal courts. Using the courts may be time consuming but the system does work.

As noted, the Baltic countries are still struggling to control unofficial, illegal, questionably legitimate and black economy activities. They do not occupy admirable positions in international corruption rankings, though they are increasingly taking stronger measures to fight and prevent corruption. With EU membership on the horizon, these countries have a particular incentive to fight corruption and have set up local anticorruption agencies to fulfil EU requirements. During the negotiations for EU membership, one requirement imposed on Latvia, for example, is to improve its administration's effectiveness.

What is the impact of entry into the EU by the Baltic countries? They are already stable areas for investment but will certainly become even more reliable regarding future development in the society. This could increase foreign investment. Rumours about increased foreign activity in the real estate sector after the referendums are already circulating. If the countries join the euro zone the currency exchange risk would disappear.

In Finland, accession to the EU did not signify such a drastic change as some might have predicted. Today, when the country has been a member for almost nine years, the general perception in business is that the influence of the EU has been positive and that the worst fears have not been realized. For Finland, agriculture was the main concern and it is also an issue for the Baltic states. Since EU legislation has already largely been adopted, no radical changes are expected in the legislation of the Baltic countries.

What are the biggest challenges and opportunities for the Baltic countries? During the past transition period, the main trading partners, particularly for Estonia and Latvia, have been EU and Scandinavian countries instead of the former Soviet block.

Membership should no longer make a substantial difference to trade because free trade agreements have been in force for quite a long time. Certain tariffs (for example, on food products) with non-EU countries will arise as a result of the membership.

Because of their location and year-round open ports, Baltic countries could form a trading link between Russia and EU countries. However, at the moment the political tension, particularly between Latvia and Estonia on one hand and Russia on the other, complicates this.

When Finland joined the EU in 1995 the structural funds available were on average (for 1995 - 1999) €277 million a year.

The corresponding figures for the Baltic states are on average (for 2004 - 2006): Estonia €113 million, Lithuania €274 million and Latvia €192 million. In relation to the GNP the Baltic countries could receive on average eight times the amount Finland got from the structural funds alone.

For the Baltic states, the EU has also committed the same level of funding with cohesion funds. Finland did not get any cohesion fund support. The purpose of structural and cohesion funds is to diminish differences in development level and economic circumstances between regions and member states and thus promote cohesion in the EU. Cohesion funds are only available for member states with a GNP below 90% of EU average.

The availability of EU funds (totalling €3 billion during 2004 - 2006 for the Baltic countries) could have a significant impact on the economies, as the amounts are substantial in relation to the GNP of these countries. This is clearly different from the accession of Finland and Sweden.

These countries will have prospects and opportunities as a result of their accession, especially if they are able to receive potential EU funding efficiently.

Author biography

Mika Salonen

Borenius & Kemppinen

Mika Salonen is an attorney working in Helsinki and Riga. He has been a partner since 1997 and is responsible for the Baltic operations of Borenius & Kemppinen. Salonen has wide experience as a business lawyer in the areas of M&A, capital markets, finance, corporate restructuring, contract law, as well as IT and entertainment law. Salonen received his Master of Laws degree in 1989 and was admitted to the Bar in 1994. He also completed an LLM degree within the European Community Business Law programme at the University of Amsterdam in 1992.

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