Global Legal Update (#09 September 2013)

Protection of Foreign Investors from Local Takeover in Estonia

Leonid A. Tolstov

One of the main concerns for foreign investors who invest in companies that are not publicly traded is how to have an adequate overview of and control over their investments locally. Merely signing a shareholders’ agreement and reading quarterly statements does not guarantee that local shareholders together with members of the management board who are under their control will not misuse their insider position to the prejudice of foreign investors. The Estonian Supreme Court made an important judicial precedent on the protection of (foreign) investors already on 31 March 2010, though it did not come into force until 26 November 2012.


An emotionally moving event happened in a small town called Tartu in Estonia, during the restoration of independence of the Republic of Estonia in 1991 when two brothers who had been separated from each other since the end of the II World War met again. One of the brothers, Mr. Vambola Raig had been taken to the USA when he was a child and he had lived there his entire life. The other brother, Mr. Neeme Raig had stayed in Estonia. When the two brothers met again they were both in a respectable age and had already achieved quite a lot. Mr. N. Raig, the brother who had stayed in Estonia, had become a director at a large enterprise (in a local sense) manufacturing baked goods during the Soviet times. Mr. V. Raig, however, had the capital and Western experience. So it was decided to privatize the above mentioned bread industry, Pere Leib Ltd together and divide the shareholding equally between brothers.


By 2004 the relationship between the brother shareholders had become complicated. Mr. N. Raig was probably disappointed by the fact that his brother, who lived mostly in the USA, was only a passive shareholder while the local board and shareholder carried the whole burden of managing the company. That might have been the reason why Mr. N. Raig started to single-handedly alter the balance of powers between the brothers.

In the meantime, Pere Leib Ltd had acquired a holding of over 90% in a smaller Estonian bread industry, Cibus Ltd. Although, as a rule, resolution of shareholders of all merging companies is needed for the merger of companies, Article 421(4) of the Estonian Commercial Code states an exception to that rule, according to which, resolution of shareholders of an acquiring company is not required if at least nine-tenths of the share capital of a company being acquired is held by the acquiring company. Despite the fact that the purpose of this regulation is to simplify the process of carrying out mergers within groups, the mentioned provision provided an opportunity to change shareholders’ holding proportions unilaterally in the current case.

In the case under question Pere Leib, as a parent company, owned more than 90% of Cibus’s shares. In addition, Cibus had a minority shareholder, Frominer Plc as well and the sole shareholder and owner of that company was Mr. N. Raig. As a result of the merger Pere Leib acquired Cibus’s assets and the shares of Cibus’s current minority shareholder (Frominer) were replaced with the shares of Pere Leib. The effect of the above mentioned merger was that the shareholdings of both brothers in Pere Leib fell to 49.5% and, at the same time, Cibus’s former minority shareholder Frominer acquired about 1% of the shares of Pere Leib as a replacement. Simple mathematics shows that although the shareholding of both brothers fell in an equal amount as a result of the merger, Mr. N. Raig together with Frominer, which was under his control, acquired a majority in Pere Leib with 50.5%.

As the merger did not require for a meeting of Pere Leib’s shareholders to be called in the given case and V. Raig was unsuspectingly in the USA at the time, V. Raig did not find out about the change in his shareholding until entries in the registry had been made and the possibilities for contesting the merger passed. Further activities had harsh results for V. Raig — distribution of dividends to shareholders was terminated and just half a year after the merger another division took place, during which the whole production was transferred to Pere Leib’s subsidiary. Also, several other transactions took place later as a result of which Pere Leib lost control over its subsidiary handling production and what was left of Pere Leib was just an empty shell.

Difficulties in enforcing Mr. Vambala Raig’s claim

Although Mr. V. Raig had lost his entire investment, the scheme seemed to be legally correct and two courts of the first instance left his claims against Mr. N. Raig fully unsatisfied. The main problem of the situation was that even if there was a procedural mistake in the way the merger was carried out, Mr. V. Raig’s shareholding decreased only ca 0.5% and from the point of view of accounting the value of his shares was affected minimally. Furthermore, as Mr. V. Raig did not have majority holding prior to the merger either, the lower courts found it hard to agree that there was any damage at all caused to Mr. V. Raig due to the merger. All the latter transactions, howe- ver, were considered as being part of the usual business risk and the co-shareholder Mr. N. Raig could not be held liable for that.

The main difficulty was that due to lack of judicial practice in Estonia, no one was able to put a price on the right of veto. It was obvious that the value of the right of veto was higher than the accounting value of the 0.5% shareholding the plaintiff lost. According to experts who were involved in the case, it could be said, based on similar research carried out in the USA, that the discount rate of a minority holding usually remains between 27–33% (for example, if the price of a 50% shareholding was EUR 10 million, the price of a 49.9% shareholding would decrease to EUR 6.7–7.3 million simply due to the loss of the right of veto).

Main positions of the Estonian Supreme Court

The Supreme Court annulled the judgements of lower courts and sent the case to be reviewed in the court of first instance. At the same time, the Supreme Court set forth several positions of principle, which later significantly affected investment making in Estonia and settlement of similar disputes.

The Supreme Court was of the opinion that the activities of a shareholder carried out with the aim to gain control over a company or its economic activities could not be considered being in accordance with good morals and allowed if dishonest means were used and other shareholders were overridden in the process. Even if the means used to achieve that purpose were not directly contrary to the law, acting for such an aim might be unlawful. The Supreme Court found that in the case of a company that has two shareholders of equal holding, acting without the will or knowledge of the other shareholder in order to acquire a majority in the company, to transfer the assets of the company under the economic control of one shareholder or achieve another purpose as a result of which the other shareholder would lose control over the company’s assets and his/her holding would become basically worthless could be considered being contrary to good morals.

With that reasoning the Supreme Court satisfied Mr. V. Raig’s action against Mr. N. Raig in full and ordered payment from Mr. N. Raig for damages caused due to the decrease in the value of shares belonging to the plaintiff. The Supreme Court was in agreement with the method for calculating damage proposed by the expert included in the case; however, the court went even further in its judgement. Namely, the Supreme Court was of the opinion that transactions that took place after the merger and decreased the value of Mr. V. Raig’s shares practically to zero had to be taken into consideration as well. Therefore, the court found that in order to ascertain the amount of damage to be compensated, the value of the shares prior to the merger had to be determined and compared to the value of the shares as at the time of the making of the court judgement (or at the time as close to making the judgement as possible).

In addition, the court found that the company’s board should be held liable for damage caused to the plaintiff as well, since in order to change the shareholders’ share proportion and include a new shareholder during the merger, the size of the share capital must be changed, but that can only be done on the basis of the resolution of a general meeting (independent of the fact that resolution of a general meeting is not needed to decide merger). Therefore, as the requirement to call a general meeting was violated and due to that damage was caused to the plaintiff, members of the board must be held liable in an extent equal to the liability of Mr. N. Raig.

Impact of the judgement on Estonian investment climate and judicial practice

The judgement in question has had a significant effect on inbound investments in Estonia. There has been a shift in the mentality of privatization times and people have come to realize that it is no longer possible to acquire whole companies with cunning legal schemes. That in turn should especially assure foreign investors when managing their investments from a distance as there is always a greater risk that locals may take advantage of the absence of foreign investors and turn the inbound investments into their own gain.

Latter judicial practice has also changed a lot on the basis of the Supreme Court’s guidelines. Although circumstances in different cases are not the same, the above mentioned general principle of good morals has been applied in several cases enable the crushing of the seemingly legally correct schemes of the defendants and their defence policy based on those schemes.

Despite the fact that Estonia is one of the smallest members of the European Union, it is still an equal partner in terms of legislation and, therefore, the positions of the Estonian Supreme Court expressed in the article are surely relevant in the EU as a whole. Merger regulation of public limited companies is harmonized at the EU level and based on the EU Council Directive 78/855/EEC of 9 October 1978, which means that the process of mergers for public limited companies is in all EU countries generally the same. Consequently, the experience of Estonia concerning a merger dispute should certainly be of interest to other member states of the EU as well.

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