Czech Republic

Author: | Published: 4 Jan 2001
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In the decade since the fall of communism, the Czech Republic has become an attractive market for private equity and venture capital investing. Several factors have contributed to this influx of capital.

  • the Czech Republic is a low-cost producer of goods and services, and is located centrally in Europe;
  • the Czech crown is a relatively stable currency;
  • the population is highly skilled and well-educated;
  • civil and legal practices are generally within the established European framework.

Accurate figures for the total amount of private equity and venture capital investments in the Czech Republic are not available. Nevertheless, the amount of foreign direct investment (FDI) can provide an indication. According to the Czech National Bank, FDI in the Czech Republic at the end of 1993 was $653 million, rising to $2.3 billion in 1995. After the financial crises of 1997, FDI fell to $1.2 billion, but has since risen dramatically. As a result of certain investment incentives approved in 1998 by the Czech government, in 1999 FDI increased to $4.9 billion. In 1999 and 2000, increased privatization activity resulted in accelerated FDI, which is estimated to have exceeded $6 billion in 2000. Among transition economies, only Poland and Hungary have attracted more outside investment capital. With respect to future investments, it is hoped that the recent overhaul of the Czech statutory scheme, and in particular, amendments to the Czech Civil Procedure Code regarding much-needed judicial reform, will accelerate FDI.

While inflows present an optimistic picture, the amount of FDI in the Czech Republic has generally been correlated with GDP growth, and certain factors may slow economic output, reducing the desirability of Czech investments. Czech companies which are primarily Czech-owned, have not enhanced productivity to the same extent as companies with significant foreign ownership. As a result, a significant number of Czech companies are undercapitalized and near insolvency. Similarly, the cost of government administration, and state debt obligations, are high in relation to EU standards. The inability of the government to decrease state budget deficits as a percentage of GDP, constrains spending for much-needed infrastructure improvements. Deficits are exacerbated by the growth of mandatory state expenditures in the form of social transfer payments, defence spending, debt services and other costs, which reached almost 84% of public spending in 1999. Increasing tax rates, which are already high, are not a viable solution for lowering public debt. The lack of an efficient judiciary and professional civil service have further hindered economic growth.

Legal developments

In accordance with the aim of joining the European Union, the Czech Republic has been addressing these structural deficiencies, including recent amendments and additions to (among other statutes) its company, commercial and securities laws in order to harmonize with EU directives. While the amendments are important steps for EU integration, they appear to be deficient in some respects. Most significantly, the effectiveness of recent judicial reforms is untested, and creditors' rights, though strengthened by recent legislation, may still be difficult to enforce. Additionally, the new legislation appears to complicate the process for the sale of an enterprise, which is a common method of business acquisition in the Czech Republic. Accordingly, while the amendments help in some respects, in others they fall short of the systematic reform needed for full development of capital markets.

Although it is difficult to predict the practical affects of these amendments, the following is a summary of the changes which are most likely to have a significant affect on private equity and venture capital investment in the Czech Republic.

Mergers

The amendments will facilitate merger activity by allowing mergers of certain business forms that were not allowed under the previous Commercial Code. Previously, only entities of identical business form could be merged. For example, only a joint stock company (a.s.) could be merged into a joint stock company. Accordingly, if a proposed restructuring contemplated the merger of a joint stock company with a limited liability company (s.r.o.), one of the entities was required to change its corporate form, a burdensome process. However, under the revised Code, joint stock companies and limited liability companies, or limited partnerships and general partnerships, may be merged together. The amendments also require more extensive public notice and stricter accounting with respect to the transformations. The changes, however, are in accordance with EU directives.

Additional minority shareholder rights

Also in accordance with EU harmonization, shareholders with shares worth 5% of the registered capital of a Czech joint stock company, and 3% for companies with more than Kr100 million ($2.4 million) of registered capital, now have the right to call a general meeting of shareholders. Under the former Code, the threshold for any joint stock company was 10%.

Minority shareholder squeeze-outs

In accordance with most European jurisdictions (but not the UK), Czech law does not provide an acquirer of a minimum percentage of shares of a joint stock company with the right to purchase 100% of the company's shares from minority shareholders. On the other hand, while an acquirer cannot purchase 100% of a company, acquirers which do not carefully plan and execute share purchases may be forced to buy more shares than required for a controlling interest. If an acquisition of shares equals or exceeds thresholds of 40%, two-thirds or three-quarters of the voting shares of a company, an acquirer is obliged to make a public tender offer for all remaining shares.

Corporate governance in the Czech Republic labours under the system-wide problem of the absence of minority shareholder involvement in the affairs of certain large privatized Czech companies, which is a result of the method of voucher privatization that occurred in the Czech Republic. Indeed, in our experience, a significant number of minority shareholders will not sell their shares, no matter how advantageous a tender may be. Accordingly, many commentators have seen a special need for minority squeeze-out rights, and the failure of the new amendments to address this problem is unfortunate. Eventually, however, we expect that minority squeeze-out provisions will be adopted which are similar to those in effect in the UK, in accordance with EU directives.

Increased controlled company reporting requirements/control agreements

The amendments have increased public reporting requirements for managing boards of Czech enterprises which are subsidiaries of or controlled by, other entities. Although the controlled and controlling entities may avoid the public reporting requirements by executing a control agreement, the public disclosure requirements for control agreements are equally onerous. Accordingly, while the exact application of these new requirements remains unclear, they appear to place significant additional burdens on control-interest owners and managers.

In general, the amendments require that management boards of joint stock companies or limited liability companies (the provisions also apply to limited and general partnerships), which are wholly owned subsidiaries or controlled entities, make available to the public annual reports which describe in detail all transactions and other contractual commitments between the parent and subsidiary or controlled entity. If the controlled entity can demonstrate that it is has been harmed by the controlling entity (the nature of the harm is not yet clear), the controlled entity may bring an action against the controlling entity. The directors of the controlling entity are personally liable for any non-payment of damages by the controlling entity as a result of any such action.

The controlling and controlled entity may opt out of these requirements by executing a control agreement. Under a control agreement (widely used in Germany, and the subject of EU Directive 9, not yet adopted), a company may "submit to the control exercised" by the controlling shareholder. The controlling entity may instruct the controlled entity, even if the results of the instruction are unfavourable, and need only act with the "due care of a prudent businessman". The controlling entity must indemnify the controlled entity and may also be liable to creditors and shareholders or members of the controlled company, for damages caused as a result of the breach of the duty of due care.

Control agreements are approved by a general meeting of shareholders, and are subject to an affirmative vote of three-quarters of the shareholders or members attending a meeting (although the articles of association can require a larger majority). Stakeholders who do not vote to affirm the control agreement (outside members) have the right to sell their shares or member interests to the controlling entity for a limited time after the control agreement becomes effective and have recourse to the courts if they believe the purchase price for such minority shares is reasonable. However, the controlling and controlled entities have extensive reporting requirements to outside members with respect to the control agreement, and the repurchase price for minority stakeholds.

Sale of enterprise – public notice requirements

The amendments to the Czech Commercial Code have added what appear to be significant statutory requirements for enterprise sales. Apart from a 30-day notice period, the amendments require that the applicable parties make all of the commercial terms of the enterprise sale available for public inspection. The amended Commercial Code provides that an enterprise sale agreement may be executed and made effective upon the resolution by the applicable governing bodies of the purchaser and seller. However, at least one month before the entry of the resolution, the purchaser and seller must complete a draft of the applicable sale agreement, which should set out an accounting determinative date, ie the date on which the purchaser starts operations with respect to the purchased enterprise for accounting purposes, and to provide public notice of the sale by filing the draft sale agreement with the Czech Commercial Register. An announcement of the filing, and notice to all creditors of the seller, and all applicable equity stakeholders of entities involved in the sale regarding rights which may be affected, must be published in the Czech Commercial Bulletin.

Additionally, new accounting requirements apply to enterprise sales. Concluding financial statements must be prepared on the date immediately preceding the accounting determinative date of the enterprise sale. The purchaser must prepare an initial balance sheet for the determinative date, and an auditor's report must be delivered regarding the concluding financial statements and the initial balance sheet. The new accounting requirements, while not necessarily unreasonable, will make the sale process somewhat less flexible. While a prudent purchaser is likely to prepare these reports in any case, in certain circumstances audits of the financial reports may not be warranted.

Of greater concern are the additional notice requirements for the commercial terms of enterprise sales. Czech commentators have praised the changes because they are viewed as bringing transparency to the market; the publication of commercial terms leaves less room for financial misdealing. However, public notice of the commercial terms of an enterprise sale is not the norm in Europe. While the effects of the new requirements are not yet known, predictably, purchasers will be reluctant to publish the commercial terms of a draft sale agreement, and enterprise sales may be used in more limited circumstances in the Czech Republic. This would obviously be an undesirable outcome for private equity and venture capital investors, because the relative ease of acquiring businesses through enterprise sales has been an attractive feature of mergers and acquisitions law in the Czech Republic.

Conclusions

The recent amendments to Czech law are another significant step towards EU membership. Apart from public notice requirements for enterprise sale agreements, the amendments are generally in accordance with applicable EU Directives. This article highlights certain significant developments in the Czech Republic regarding private equity and venture capital investing, but is not meant to provide an in-depth analysis of such developments, nor does it provide a comprehensive review of all recent amendments to Czech law which might affect investing. We would be pleased to respond personally to any further questions the reader may have regarding these developments.

This article was drafted before the effective date of the amendments, which is January 1 2001. Please consult the IFLR website at www.IFLRnet.com for developments regarding these changes.




Weil, Gotshal & Manges

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Prague 1
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Czech Republic

Tel: 420 2 2140 7300
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www.weil.com