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Legal structures in Poland

Poland's private equity industry is governed by a simple legal structure, as is most of Central and Eastern Europe. Thomasz Dabrowski and Todd Peterson of Salans discuss the problems that the country faces as a result of such structures.

The legal world of private equity transactions in Poland, as in much of central and eastern Europe, continues to be dominated by a fairly simple set of documents. Local practice reflects the continuing blur in the region between private equity and venture capital transactions, efforts to ensure the enforceability of documents, and the need to coach transactions from the money side rather than having them pulled from the borrower's side.
The convergence of private equity and venture capital

Although there are a wide array of private equity funds active in Poland, most of them tend to concentrate almost exclusively on Poland, and therefore tend to reflect a continuing focus on issues arising from that focus. This is understandable given the much larger size of the Polish market compared with those of the potentially competitive markets in the region, as well as the continuing focus on Warsaw-related businesses and high-end transactions.

This appears to be changing, as more and more funds shift away from consumer-led transactions (which seem not to have fared as well so far as those led by business-to-business related transactions). At the same time, however, funds continue to focus on larger transactions (upwards of $20m) which remain quite scarce. They also continue to have to focus on transactions involving only Poland, rather than having the luxury of being able to look at related businesses throughout the region. This contributes to a blur between venture capital and private equity transactions, commonly differentiated in more developed markets, and continues to drive legal documentation towards fairly simple but highly negotiated sets of documents.

This is beginning to change as consortia gradually appear, although much is left to develop in this area. One fairly recent example is the development of a mezzanine finance market, although this too is quite undeveloped at this point.

The enforceability of documentation
Many of these issues may be based on problems with enforceability, which continue to hang over the documentation typical in a standard private equity transaction in Poland.

Deals almost always begin with a confidentiality agreement. Although problems relating to the effective enforcement of such agreements are not appreciably different from difficulties in more developed markets, both sides often wrangle over such agreements. Most continue to be negotiated in English with a Polish translation. The latter is required by law, but the agreement may indicate that any discrepancy is to be resolved in favour of the English version - even if that does raise a different set of enforceability issues related to courts and arbitration options.

It is still common for companies to want to insert a financial penalty for breach of confidentiality obligations, especially if a fund already has a competitor company in its portfolio. But it is very unusual for a fund to agree to such a provision. Unfortunately, this battle may only intensify over time, as funds gradually begin to assemble portfolios of companies together to sell them to strategic investors or bundle together a more attractive initial public offering. For now, the end result continues to be a fairly simple confidentiality agreement, touching almost all of those issues commonly dealt with in developed markets throughout the world. Exclusivity continues, for example, to be something that funds would love, but something that few of the companies whose deals are sought after are willing to grant. This is bound to change as the market continues to develop, and should be included in any responsible confidentiality agreement - at least in the initial drafts.

The next step of the deal is fairly predictable, with a letter of intent or memorandum of understanding. The largest complication here is that it is still common for parties to proceed with a handshake through this process, taking the risk that the deal may blow up (or that a better suitor will arise). For those parties that engage in believing they have tied up a deal, proposed letters of intent and memoranda of understanding again look fairly similar to those in more developed markets, although they tend to be fairly simple.

It is common for such documents to only be a page or two in length, doing their best to touch on all the main issues, but seldom going into detail on any single provision. This includes the typical language that they are not intended to be legally binding - a principal which has not seriously been tested in the Polish market yet. This even extends to fee provisions, which are commonly inserted but seldom enforced in the few instances when deals collapse. However, the current trend is to try to ensure that they remain binding (with the one large question remaining of where it would be best to test the provision should that be necessary).

Next, the parties get serious, and go to work on shareholder agreements. Here again, the most common legal issue is the same as in more developed regions of the world: the effective enforceability of provisions remains questionable. This is mostly because it is of little comfort to receive monetary damages (at best) when investors do not end up with the voting rights they believed they had. The difference remains one of insiders versus outsiders, with it still common for those in Poland to doubt those who are offering them money (and of course hoping for profits). Unfortunately this is not without good reason, with a few well-known examples of individuals doing their best to get the Polish courts to grant them amounts nobody would have believed possible. Meanwhile, a few too many Polish judicial bodies still give in to the temptation to recreate fairness at a much later stage of proceedings than was initially negotiated. Thus, it is common for parties to go beyond the borders of Poland for the purposes of their shareholder arrangements (and because of tax issues, this tends to make sense more often than not). Nevertheless, enforceability issues remain, and may even be compounded based on where parties' assets are located and how difficult it is to import a foreign court judgment into Poland.

The typical end-product shareholders agreement once again looks more often than not like its western counterpart, covering voting issues, management issues, minority shareholder issues, exit issues and the like, although seldom in a very complicated manner.

Perhaps the biggest explanation for the simplicity of shareholder agreement provisions is that much of the substance of a typical private equity transaction in Poland continues to be covered in operating company documents - most notably the articles of association of a company. The most important reason for this is that such articles must, by law, specify certain principal management issues. At the same time, some of the share transfer or voting restrictions would not be enforceable were they not included in the articles. On top of that, filing judges must decide whether they understand these provisions well enough to allow them to be filed in a registry court. This is one more matter that appears to be getting better over time, even if difficulties continue to persist. All of this creates a real reason for such agreements to be pushed down to the operating company level: because that is where the assets are. This is overlooked too often. Companies may not understand that a holding company can be good for company founders as well as funds for tax reasons. Or they may not understand how such a structure works should the funds try to hold shareholder meetings for the operating companies by themselves (at which point the founders and managers simply threaten to revolt if ignored - negating whatever deal the parties may believe they agreed).

Meanwhile, perhaps the continuing most sensitive agreements are those relating to employment, management and incentives. Here the trend is to try to differentiate between employees and managers, for some fairly suspicious reasons relating to what various advisers continue to insist labour courts will overlook, as well as to the all too often upside-down view of labour law as mostly protecting employers. The second reason is changing more quickly than the first, but the continuing effect is to engage in a number of complicated (and maybe or maybe-not enforceable) arrangements with respect to bonuses, non-compete agreements and day-to-day management agreements.

Here there is seldom a typical arrangement, with virtually none of them tested anywhere. These deserve deal-by-deal investigation, mostly because situations commonly arise where management, whether Polish or foreign, is overpaid and under-performs, and where debates rage on as to which agreement is supposed to result in what effect on any number of related parties. Here it is only possible to introduce the flavour of complexity. For example a company president may have a local operating company employment agreement (for a nominal amount), a holding company management agreement or non-compete agreement (or both, and for a more substantial amount), and one or more variations on stock options (which can be granted in Poland - although there are shareholder approval issues which can arise, but can also be circumvented by financially penalizing a company if the shareholders do not adhere to the agreement, or alternatively can be granted at a foreign holding company level).

This leads to the legal conclusion that the most difficult issue confronting all such agreements is that of enforceability. This is primarily due to the non-reciprocity of foreign judgments in Poland, with only minor exceptions. This simply means that even if you win a legal battle outside of Poland, a Polish court will not enforce it until it is re-litigated in Poland, with no guarantee of a similar decision.

The problems are also due to the common practice of deciding to turn to Polish arbitration courts, which most advisers continue to recommend, although not for many convincing precedent reasons, even if arbitration can be conducted in English. The only way around this seems to be to turn to some kind of foreign arbitration, which generally will be upheld in Poland with relative ease. But this raises the question of where one finds an arbitration tribunal that both sides are comfortable with. Austria, Sweden, England and even New York continue to be common choices.

Apart from enforceability concerns (which in fact are not that uncommon elsewhere either), most other legal issues (apart from the mess of management arrangements) continue to reflect simplified versions of what one would expect in western Europe. This trend seems to be continuing, with perhaps more of a bent towards Anglo-American traditions rather than those of civil code jurisdictions.

Negotiations
This places even more emphasis than may be expected on the negotiation process, which continues to be one of the more notable aspects of a typical Polish private equity transaction. From the perspective of a fund, it demands a great deal more hand-holding than one would typically expect from a place where end documents tend to look so familiar. From the point of view of a Polish company, negotiations are the largest cause for angst as foreign money flows into their enterprise. For the advisers, the difficulty of the negotiations explains why transactions in Poland tend to take a relatively long time to complete. Governmental approvals are sometimes seen as a delay also, but although everyone complains about antimonopoly and ministry of internal affairs approval with respect to real estate issues, these seldom cause delays longer than six months.

Once a fund has convinced a company that taking money makes sense, one of the most common issues to arise relates to whether a holding company should be put in place to guard the transaction. Reasons for this are wide-ranging and often compelling:

• to ease the management of the assets in the operating company;
• to enable an exit in the future;
• to increase tax efficiencies; and
• to assist in the management of the business.

With respect to managing the assets, private equity fund deals in Poland generally use existing management, although of course there are some exceptions. This means that the least intrusive deal is for the company to continue operating as before, and to have the money flow from a holding company under the control of the fund. From a documentary point of view, it is easiest to leave the company documents untouched, and to put shareholder and other issues in a separate entity. This is especially true where the company is profitable and the fund is simply focused on getting a return on its investment as the company does more of what it has already been doing well. Many funds also continue to employ significant numbers of non-Poles, so it is not uncommon for language to be an issue in terms of operating the assets concerned. These issues almost always arise when laying the groundwork for the deal.

The fund will also be thinking about its exit strategy. Again, a holding company structure makes sense for a number of reasons. First, a Polish-only initial public offering will not be as attractive as a regional one. Second, some funds continue to believe that the exercise of rights of first refusal, drag-along rights and tag-along rights will be easier in a more familiar jurisdiction. Because lawyers are able to adapt these clauses so monetary damages and also specific performance remedies are available in the case of a breach, this bias against the Polish legal system may be unfounded. But it is true that few exit provisions have been tested in Polish courts. As time progresses, this view may change, and already now is rare in medium or small transactions. Whether it will reverse the trend to use a foreign holding company remains to be seen, primarily because of the question of market size upon exit. Of course a healthy Polish stock market might change that.

A more tricky negotiating issue relates to taxes, with obvious effects on the choice of jurisdiction for the holding company. As more and more deals are done in Poland, parties are becoming more sophisticated with respect to location. But this is happening slowly, with tax havens often avoided simply because they sound suspicious (even if Cyprus continues to be used from time to time), and other countries considered only because they have been used by others in Poland in the past. Dutch BVs remain common holding companies for Polish private equity transactions (justified in part because of favourable tax treaties). US entities are also common (based partly on tax benefits for the funds and tax benefits for the original shareholders of the Polish operating company). Although one would assume the choice would be a rational exercise, it is often far too emotional, at least on the side of the company. In part this is because few businesses have taken private equity financing before. Overlooking that important fact continues to impede the entire process of closing a transaction in Poland.

Other management issues again argue in favour of holding company structures for Polish private equity transactions. This gets to the heart of negotiating complexities, for a number of reasons. First, existing management for typical Polish private equity targets tend to be a small number of Polish individuals who have had some kind of foreign experience. That tends to mean they have been involved with foreign companies, and non-Polish income. It also commonly means that they are familiar with some type of tax shelter. Even if this is not the case, when the fund exists jointly with Polish shareholders, those individuals tend to seek tax savings on the proceeds from the share sale and come up with offshore tax structures shortly before a sale. Of course, this does not ease the exit process or negotiations with a strategic investor. This is a good incentive for funds to raise the issue of tax planning by its Polish partners as early as possible.

If expatriate managers are involved, they are even more likely to have turned to non-Polish companies in the past, and are just as likely to want some benefits going outside of the Polish structure. Of course this will apply to incentives as well as compensation. Working through these issues commonly remains the most difficult part of structuring a Polish private equity transaction. This looks likely to continue for some time.
In conclusion, the typical Polish private equity transaction continues to be led by an array of issues perhaps more common to venture capital deals in more developed countries. Earn-outs and adjusted subscription prices still seem to be a long way off, even if vesting periods are fairly common already. Enforceability issues continue to cloud the entire process, often because of inexperience in doing transactions, especially on the company side. This is likely to fall away over time, even if that is not happening yet because economic circumstances have delayed exits and made many fund managers hesitant about moving quickly on to the next deal.

In the long run, those deals will happen, and entrepreneurs in Poland as well as the legal system will come of age. And Polish private equity transactions are likely to continue to look more and more like their counterparts in the west.

Copyright © 2003 IFLR

Tomasz Dabrowski and Todd Peterson are partners at law firm Salans.

Salans is an international law firm with offices in Europe, the US and Central and Eastern Europe. For more information please visit www.salans.com

With kind permission of the IFLR. To subscribe to IFLR, or for further information, please contact Simon Oliver, Associate Publisher on 44 (0) 207 779 8496 or fax 44 (0) 207 779 8665 or email soliver@iflr.com