A merger proposal made this Summer sought to break new ground in the Latvian energy sector. However, it is currently on hold for legal and political reasons.

The Latvian government had long listed Latvenergo, the state owned electricity company, among the companies which it intended to privatize. While the company was essentially profitable, it was recognized that in order to retain and improve competitiveness in an increasingly open international energy market, Latvenergo would need access to know-how, cheaper forms of finance and other markets. This was especially true in light of long-term proposals to link the various energy suppliers and consumers around the Baltic sea region.

Privatization was regarded as the answer. In anticipation of this, the Saeima (the Latvian parliament) passed the Energy Law on September 3 1998. This law envisaged the partial privatization of Latvenergo. However, it stated that the hydroelectric power stations located on the Daugava, Latvia's largest river, together with Latvenergo's high voltage lines and the underground part of its underground gas storage facilities, are strategically important state power supply assets, and as such must be retained in the ownership of the state. However, even this proposed partial privatization elicited protests from some political parties.

The government has considered several privatization proposals since the Energy Law was passed. It took its first steps towards achieving this on February 22 2000, when the Cabinet of Ministers passed Decree 82 on the Restructuring and Privatization Provisions of the State Joint Stock Company to be Privatized, 'Latvenergo'. The decree provided for the restructuring of Latvenergo into a group structure. Its operating assets would be transferred to a series of subsidiary companies and Latvenergo would remain a wholly state owned holding company. The decree did not allow for the privatization of the holding company.

Other than allowing for the privatization of certain assets which are unrelated to Latvenergo's core operating services (eg, sports facilities and hospitals), the decree suggested the privatization of just two thermo-electric plants in Riga. However, the proposal was sufficient to cause a political backlash. This resulted in the organization of a petition, requesting that a referendum be held in order to decide whether the Energy Law should be amended to remove the possibility of even partial privatization of Latvenergo.

After the passing of Decree 82, and despite the threat of a referendum, the Latvian government continued to prepare for Latvenergo's restructuring, with a view to its eventual partial privatization. In the meantime, however, a proposal was tabled by Latvia's northern neighbour, Estonia. Estonia was also seeking long-term development solutions for its quasi-state owned electricity company, Eesti Energia, without formally privatizing the company. Since Estonia had not formally sought to privatize Eesti Energia and Latvenergo's privatization was subject to political scrutiny, the proposed merger of the two state owned electricity companies was seen as an effective way of reaping the benefits of privatization without actually selling off any of either state's assets.

The initial merger proposal suggested that the shares of both Latvenergo and Eesti Energia would be invested into the share capital of a holding company (Holdco). The shares in the holding company would be split between the Latvian and Estonian states. The initial negotiations turned on (i) how Holdco's shares would be split between the Latvian and Estonian states, since Latvenergo was the larger and more profitable of the two companies, and (ii) where the headquarters of the merged companies would be located. Given that both parties to the merger are state owned companies, they took an interesting view on where Holdco should be registered, initially considering that a foreign jurisdiction might be preferable for tax reasons.

Nonetheless, the proposed structure of the merger raised serious legal questions, which have no precedents in Latvian law. The first of these was whether the transfer of all of Latvenergo's shares to Holdco could be considered as a privatization of Latvenergo. According to the Latvian Law on the Privatization of State and Municipal Property, the share transfer would not be considered to be a privatization if the Latvian state remained the sole owner of Holdco's shares. Therefore, Eesti Energia's status as a shareholder of Holdco meant that the transfer would be regarded as a privatization under Latvian law. The solution to this problem would have been to remove the Energy Law's restriction on the privatization of the strategically important state power supply assets. However, in view of the prevailing political climate and the increasing likelihood of a referendum, this was not considered to be a viable option.

An alternative would have been to restructure Latvenergo on the lines envisaged by Decree 82, that is, to transfer Latvenergo's assets into various subsidiary companies, some of which in turn could be used to capitalize Holdco. This option posed less problems legally, although the same practical hurdle remained, in that Decree 82 acknowledged the provisions of the Energy Law in stating that the strategically important state power supply assets could not be subject to privatization. Unfortunately, these assets were precisely the assets which were of interest to Eesti Energia and which would have been of greatest value to Holdco. Once again, the scheme foundered on the need to remove the restrictions contained in the Energy Law.

These legal obstacles prompted the parties to consider alternative methods of combining the activities of Latvenergo and Eesti Energia in ways that fall short of an outright merger. These might include initially capitalizing Holdco with cash or other asset investments, and then requiring that Latvenergo and Eesti Energia enter into long-term lease or bailment agreements with respect to their assets. However, these arrangements may have thrown up a host of other legal issues, along with potential tax implications.

Events had overtaken the parties in the meantime. The petition requesting that a referendum be held on the issue of Latvenergo's privatization now had the minimum number of signatures required by the Constitution. The government realized that a referendum could create even more public hostility to the eventual privatization of Latvenergo. It backed down and talks with the Estonian government were postponed. The Saeima also subsequently amended the Energy Law. It did not remove the restrictions previously contained in the law, but rather expanded them to provide that Latvenergo is not privatized at present.

This last amendment to the Energy Law was allowed to pass through by those parties in favour of Latvenergo's privatization, mainly for tactical reasons. It is thus to be presumed that the issue with respect to Latvenergo will recur at some point.

For further information on this topic please contact Egons Pikelis or Filip Klavins at Klavins & Slaidins by telephone (+371 703 5222) or by fax (+371 703 5252) or by e-mail ([email protected]).

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