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From the bizarre to the merely complex: a legal perspective on the changing rules of the game in investing in Eastern Europe.

A legal perspective on the charging rules of the game in investing in Eastern Europe

Any perspective on Eastern Europe -- be it legal, economic, political, or otherwise -- must address the ongoing, dynamic changes that pervade this part of the world, which had been economically stagnant and moribund for the past four-plus decades (and even longer in the U.S.S.R.). The results of perestroika and glasnost -- with their origins in the Soviet Union but with their results throughout all of the U.S.S.R.'s neighboring states -- include a radical and constant flow of new laws, decrees, regulations, and treaties which have overwhelmed businessmen and their legal advisers alike.

While these changes have produced political instability, social upheaval, and economic shocks and paralysis, they also have created new opportunities for the U.S. businessman. They have changed the bizarre rules of the game previously played only in the centrally planned communist countries. Now such trade no longer need be with only Moscow or Warsaw or another of the East European capitals. Decentralization of foreign trade and dismantling of central planning has resulted in more East European enterprises becoming entitled to deal directly with foreigners for both trade and investment.

In analyzing the prospects for investing in Eastern Europe, the U.S. businessman can hope to find new markets for sales, new sources of raw materials, less-expensive labor, and, perhaps, a new base of exports to other markets. He cannot, however, expect to find any guarantees. While using legal and other means to reduce his business risks, the American businessman should not expect a quick return on his investment in the short run. What he can look forward to are time-consuming negotiations and equally demanding efforts toward training and educating his East European partners and their personnel in the ways of doing business in a free-market economy, with which capitalists have decades of experience and an immeasurable competitive advantage.

The challenge for the U.S. businessman will be to find the right East European partner and to conduct business successfully. It will require expenditures of manpower, both executive and technical; financial resources; and patience and understanding to succeed where others will fail investing in a newly rediscovered part of a shrinking global market. Knowing and understanding the legal structures, restrictions, and incentives in Eastern Europe should help to meet this challenge.

Legal Forms of Investment

One of the many consequences of perestroika has been a decreased interest on the part of East European business managers and workers generally in the traditional forms of trade in Eastern Europe, i.e., counter-trade, barter, and "turnkey" projects. Simple licenses of technology are now disfavored; the East Europeans have learned that they need the hands-on commitment of a partner (and not a mere licensor) who has a stake in the successful use of the transferred technology greater than merely receiving royalties.

Investment by the U.S. and other Western firms in the East European enterprises has taken the form, up to now, primarily of joint ventures, in which the two (or more) partners agree to form a separate legal entity and to share its profits and losses in proportion to their respective investments. Most recently, the East European foreign investment laws have allowed foreign companies to establish 100% foreign-owned subsidiary companies.

Both the joint ventures and the wholly owned subsidiaries now may be established in a variety of legal forms, of which the most common and recommended for U.S. companies are the limited liability company and the joint stock company. By and large, these legal forms are similar in principal to the comparable business forms in Austria, Germany, and Switzerland, whose legal codes are most like the East European countries, most of which formerly also belonged to the Austro-Hungarian Empire.

All of these joint venture and wholly owned subsidiary companies are separate entities under local law with limited liability. Their "charters" are negotiated by the partners, together with joint venture (i.e., partner/shareholder) agreements and feasibility studies, which are submitted (in most cases) for some sort of local governmental approval and, ultimately, for registration by a local court of government ministry.

Incentives Given to Foreign Investors

In addition to the general prospect of new markets for the foreign partner, the East European foreign investment laws provide a number of concrete incentives to the foreign investor. Tax and customs duty reductions are the primary incentives given to the Western partner. Two- of the three-year tax holidays are currently the norm, with possible extensions of time or partial reductions of the standard rate of the local company income tax. Tax treaties with the U.S. generally reduce the standard 20% or 30% dividend withholding tax rates, except in Hungary, where there is no such dividend tax, and in the U.S.S.R., where the tax treaty does not cover dividends. In most of the East European countries, no customs duties are imposed on imported machinery and equipment that the foreign partner contributes as capital. In some of these countries, imported raw materials, parts, and subassemblies used by the joint venture or the wholly owned subsidiary in its production activities are not subject to customs duties.

The local partner also finds incentives from investment in a joint venture with a foreign partner, not the least of which is the partial freeing of the joint venture company from compliance with the central economic plan. The foreign partner's investment of technology, imported machinery and equipment, and other assets, which can only be otherwise secured with convertible currency, results in the East Europeans' access to such items at no immediate financial cost. Finally, the foreign investment laws now generally give more control to the management of the joint venture over its personnel, meaning both greater independence from the government authorities in hiring and firing workers, and the right to provide greater bonuses and other incentives to improve productivity.

Financial Aspects of Investing

Notwithstanding all of the legal formalities, most U.S. companies interested in investing in Eastern Europe ask their attorneys: "Can I get paid in a medium that I can use? Can I repatriate my dividend in dollars or another convertible currency? When the venture is over, or if I want to sell my interest, do I have any security that my investment will be returned to me, either in assets or a currency that will be beneficial to me?"

The answers, at least in the texts of the various foreign investment laws, are all positive. In practice, there are some qualifications and restrictions that should be recognized. When the local currency is convertible, either externally, like the Yugoslav dinar, or internally, like the Polish zloty, foreign convertible currency is generally made available for the repatriation of dividends (notwithstanding that Poland's March 1990 Treaty on Business and Economic Relations with the U.S. only guarantees the conversion of 100% of the U.S. partner's share of profits earned in zlotys by 1996). In Hungary, where the forint is still "soft," the Hungarian National Bank will issue a guarantee of conversion of the foreign partner's share of forint profits into the convertible currency in which it made its investment. In the other countries, the repatriation of dividends in a hard currency requires the joint venture itself to have earned sufficient convertible currency from exports or other sources. For example, Soviet joint venture companies are permitted by law to sell their products to other Soviet organizations for convertible currency.

In all of these countries, the joint venture can export dividends "in kind" of its own products or other products purchased on the local market for the local currency earned by the joint venture from local sales. Unfortunately, in the U.S.S.R., a March 1989 decree, intending to preclude joint ventures from acting as trading companies and to require them to engage in productive, "value added" activities, prohibits countertrade by joint ventures by permitting them only to import products used in their production and to export products produced by them.

While all of the local foreign investment laws guarantee to the foreign partner its share of the assets of the joint venture upon its liquidation, there are no clear guarantees that these assets will be repatriated after conversion into a foreign currency if the joint venture had not itself previously generated such currency. Similarly, while all of these laws contain guarantees against government expropriation, most U.S. investors obtain political risk insurance, either from private insurers or from OPIC (the Overseas Private Investment Corp.), for investments in Yugoslavia, Poland, and Hungary, with such coverage for these two countries becoming available after Congress' enactment of the "SEED Act" (the Support for Eastern European Democracies Act). With the passage of "SEED Act II," Czechoslovakia and Bulgaria should also become eligible for OPIC coverage.

Capital Contributions -- U.S. Tax and Legal Concerns

For the U.S. investors, the nature of their capital contributions in Eastern Europe generally consists of convertible currencies, imported machinery, equipment, and raw materials otherwise unavailable to their local partners. While the primary investment desired by East Europeans from the West is technology -- i.e., patents, production technical data and know-how, marketing expertise, and management experience -- U.S. corporations, unlike their West European and Asian competitors, are restricted by U.S. law from freely investing such technology. Section 367(d) of the U.S. Internal Revenue Code penalizes a U.S. corporation that transfers technology in exchange for stock or an equity interest in a foreign corporation, by imputing a royalty equivalent to that which would have been paid under an arm's-length negotiated license between the U.S. joint venture partner and the local joint venture company. Until lobbying efforts can achieve the amendment of this Code section, U.S. corporations are advised to attempt to persuade their East European partners to accept a separate license of their technology to the joint venture and to blame the royalty payments on the U.S. tax law. While there are tax problems for the U.S. corporation wishing to invest its technology abroad, there remain few, if any, U.S. export controls restricting such transfers to the democracies of Eastern Europe. The U.S. Department of Commerce has relaxed its former policy requiring a U.S. validated export license for any and all transfers of U.S.-origin technical data to Eastern Europe (except Yugoslavia, which was long treated for this purpose like a West European country). Such restrictions still only remain to a significant extent with respect to the U.S.S.R., and, even then, the U.S. Department of Defense has been more willing to accede to Commerce's granting of validated export licenses on a case-by-case basis.

Risks vs. Opportunities

It should be clear that investing in Eastern Europe today is not without its risks -- political, economic, and legal. Unfortunately, the legal systems in these countries do not yet provide the type and degree of security that most U.S. companies require before making a capital investment abroad. Notwithstanding the constant adoption, enactment, and amendment of legislation, stability is not likely to be produced soon by any of the myriad of new laws constantly appearing these days in Eastern Europe.

Nevertheless, many large and midsized U.S. corporations are generally finding good, serious business reasons for at least investigating investment in Eastern Europe. Those U.S. firms with a good product, state-of-the-art technology, sufficient business management experience and personnel, and a lot of patience and long-term vision may well find that the potential benefits and business opportunities significantly outweigh the current risks of investing in Eastern Europe. But, like the fall of the Berlin Wall and Czechoslovakia's "Velvet Revolution," be prepared for the unexpected. [Tabular Data Omitted]

James T. Hitch III is a Partner with the international law firm of Baker & McKenzie in Chicago. He received an A.B. in International Affairs -- Russian and Eastern European Studies from the Woodrow Wilson School of Public and International Affairs of Princeton University in 1971, and a J.D. from Harvard Law School in 1975. He also studied in the Law Faculty of the University of Zagreb, Yugoslavia, in 1973-74. Mr. Hitch is fluent in Serbo-Croatian and Russian, having studied at Leningrad State University in the U.S.S.R. Much of his practice concerns trade and investment between the U.S. and the U.S.S.R. and countries of Eastern Europe, where he represents both U.S. and foreign clients. Mr. Hitch is currently the coordinator of Baker & McKenzie's Soviet and East European Practice Group.
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Title Annotation:Chairman's Agenda: Acquiring in Eastern Europe
Author:Hitch, James T., III
Publication:Directors & Boards
Date:Jan 1, 1991
Previous Article:Prospecting for acquisitions.
Next Article:'What's the value of this thing?' (valuation of Eastern European businesses)(Chairman's Agenda: Acquiring in Eastern Europe)

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