In Business, Trust Is Key

05/25/2011 01:59 pm ET | Updated Jul 19, 2011

For a business executive, there's nothing worse than an environment you can't trust. Of course, no corporation or investor ever has the benefit of perfect information, but you can always make well-informed decisions and take calculated risks so long as everyone is playing by -- and sticking to -- the same rules. These rules could apply to issues of transparency, investor protections, reasonable rates of return, limiting onerous regulation and a general emphasis on the rule of law.

This has come as a particularly hard lesson recently to several countries in Eastern Europe, a region of the world that, since communism's fall, has enjoyed relative economic prosperity. But if international entrepreneurs believe that their capital investments, many of which take the form of joint ventures with domestically based businesses or government entities, are at increased risk in countries like Estonia, Poland, Latvia and others, the subsequent drop in foreign direct investment (FDI) could have potentially far-reaching socioeconomic consequences. If proper safeguards are not in place, investors can very easily choose to put their money elsewhere.

Many of these capital investments help grow local businesses, support jobs, expand the tax base, improve infrastructure, generate revenue and often bolster much-needed modernization through transfers of technology. Where these investments go, however, depends on the willingness of countries to accept investments and build a long-term and consistent atmosphere that is supportive of and conducive to investment.

Legal and regulatory requirements for operating businesses have a strong impact on investment decisions. A country's overall political climate, for example -- stable? tenuous? corrupt? law-abiding? -- can play a major role in determining a country's fitness for foreign investment. And over the past few decades, broad liberalization of certain domestic trade and economic policies have helped many countries increase investment; this is particularly true when it comes to how the rule of law is applied, upheld or ignored, the extent to which a business' property rights are protected and how fairly business disputes are resolved in emerging economies.

Eastern Europe has recently played host to several heavy-handed government and regulatory actions that, taken together, recall the specter of anti-free-market communism that these countries have spent the past twenty years trying to escape. While the region has seen its (growing) share of FDI, some countries are running the risk of discouraging future investments and, as a result, will miss out on the corresponding political and economic benefits.

Two such cases are top-of-mind, and both take us to the country of Estonia. The first involves a privatized Estonian water utility, A.S. Tallinna Vesi (ASTV). The utility was privatized in 2001 by the city of Tallinn in a joint venture with United Utilities Tallinn B.V., a wholly-owned subsidiary of the U.K. water company United Utilities. The process was constructed so that all parties could receive a reasonable rate of return on their investment (based on a stable tariff regime), in return for which United Utilities would make substantial capital investments in ASTV to improve infrastructure, water-treatment processes and customer satisfaction.

According my research, it seems that United Utilities met all of its obligations under the agreement, and all quality standards were met or exceeded (approaching Western European levels). Meanwhile, tariff levels remained consistent with those of other privatized utilities.

By the end of 2009, the newly-formed Estonian Competition Authority, which was granted regulatory power over Estonian utilities, abruptly instituted several regulatory actions that unilaterally changed the contractual environment that had already been agreed to during the privatization process. Control of tariff increases was changed away from the contracted tariff regime based on a new methodology, which essentially prevented ASTV and its shareholders from earning the return it was promised by the Estonian government. While ASTV has protested this move to the European Commission, the Competition Authority continues to rebuff ASTV's request for a fair review of the decision, which clearly violates the preexisting contract.

A similar example can be found in the case of Estonian National Railways, or EVR. Founded in 1992 after Estonia gained independence, EVR was privatized and sold in 2001 in a competitive bid, the second vertically integrated national railway privatization in Europe. In the privatization bid, 66 percent of EVR's stock was sold to Baltic Rail Services (BRS), part-owned by the U.S.-based Railroad Development Corporation.

In terms similar to those in the ASTV contract, BRS assumed the obligation to invest EEK 2.6 billion in five years after the privatization into replacing railcars, infrastructure projects and technology. According to the privatization agreement, the new owners were permitted to earn a reasonable profit while ensuring safe operation of the railway.

However, once again, Estonian authorities ignored the existing agreement after an election in 2003, changing rules governing track usage and capping permitted track charges, significantly and negatively impacting the value of the railway. This basically rendered the government's contract with EVR null and void.

EVR began court challenges in 2004 in a number of jurisdictions, arguing that the new rules didn't even allow them to cover track maintenance costs; that they were essentially being forced to absorb 50 years of capital investment without the ability to recover their costs. Corporate leaders at BRS described the new legislation as having the effect of "expropriating most of the value of the company, which in turn triggered arbitration under the privatization agreement."

The owners eventually settled at a major loss, and, in January 2007, the railway was renationalized.

These scenarios can be seen throughout Eastern Europe. There's a particularity hairy and very publicly rancid case in Poland that has been brewing between the country's main telecommunication's company and a Danish headset maker that built out the country's previously antiquated telecom infrastructure in the years immediately following the wall coming down. James k. Glassman wrote a very interesting article on this dispute in Forbes.

While every reasonable investor understands that market and business conditions are fluid, in established economies it is understood that contracts are legally binding and enforceable; they can't be changed just because a new government official or regulator doesn't like what his predecessor had put in place. For example, Märt Ots, Director-General of the Estonian Competition Authority, said in a statement that A.S. Tallinna Vesi's desired rate of return does not comport with Estonia's principles of "reasonable profitability."

Violating contracts to score political points is no way to encourage investment in a growth economy. If emerging economies like those in Eastern Europe want to continue to attract and reap the benefits of FDI, governments must establish and enforce a rock-solid contractual framework for business. If they don't, investors have no choice but to believe that these scenarios will emerge as standard operating procedure, and they will choose to take their business elsewhere. That would be a shame - Eastern Europe has historically been the center of technology, science, culture and philosophy, for centuries and investors have only to gain from this region.