Ensuring a consistent regulatory framework
The first core corporate governance feature for the review calls for Estonia to ensure a consistent regulatory framework that provides for the existence and effective enforcement of shareholder rights and the equitable treatment of shareholders, including minority and foreign shareholders.
The regulatory framework for corporations
Estonia’s self-assessment states that it has either broadly implemented or fully implemented all sub-principles in Chapters II and III of the Principles as a whole.
Principle II.D states that “Capital structures and arrangements that enable certain shareholders to obtain a degree of control disproportionate to their equity ownership should be disclosed.” Estonia’s self-assessment indicates that as a general rule, the Law provides for the principle of equality of shareholders. The Commercial Code (CC) states that “shares with equal nominal values shall grant an equal number of votes.” A public limited company may issue non-voting shares which grant the preferential right to receive dividends and to participate in the distribution of the remaining assets of the public limited company upon dissolution (preferred shares). These shares provide a shareholder with all rights except the right to vote.
When establishing a company, all founders must conclude a memorandum of association stating the proposed amount of share capital; the number and nominal value of shares and, upon issue of more than one class of shares, their denotation and the rights attached to the shares, and the division of shares among the founders; the amount to be paid for shares and the procedure, time and place of payment. The Commercial Code foresees the possibility of cancelling or altering the rights of preferred shares, but only if all holders of these shares adopt a resolution to cancel or amend the preference of preferred shares. Furthermore, the Law allows for preferred shares which give rights to dividends to become voting shares, if these shares do not pay dividends for two full years. Upon the payment of dividends they become non-voting shares again.
To reduce the risk of certain shareholders obtaining a disproportionate degree of control relative to equity ownership, Estonian legislation requires that all significant holdings (including cross-shareholdings and intra-group holdings) be published in annual reports. Similarly, any new significant investments of listed companies must be disclosed in ad-hoc announcements. In addition, information on significant shareholdings in listed companies is clear and easily accessible on the Tallinn Stock Exchange website (see Annex B). It was somewhat more difficult to obtain clear data and analysis of the nature and extent of group ownership, cross shareholdings or pyramidal structures in Estonia involving both listed and non-listed companies. However, Estonian authorities asserted that because of the size of the market, it is not difficult to understand ownership structures in Estonia and that only “a few companies” have owners who have significant positions in other companies. They stated that ownership “overlapping” is more prevalent in the case of minority shareholders, who might own a limited number of shares in various companies. Supplementary information provided to the reviewing team also indicated that in general, Estonian company groups’ structure is rather simple and flat. Pyramidal structure groups are not common, according to Estonia’s self-assessment, and in a small number of cases an “issuer's free cash is invested into listed stocks or investment fund units, but such holdings would be temporary and virtually invisible in size”. However, most listed companies do have a controlling shareholder or group of shareholders. Of the 14 currently listed companies on the main market, 7 have a controlling owner owning more than 50 per cent of equity in these companies. Two companies have an owner with over 40 per cent of the shares.15
Principle II.E states that “Markets for corporate control should be allowed to function in an efficient and transparent manner: 1) The rules and procedures governing the acquisitions of corporate control in the capital markets, and extraordinary transactions such as mergers and sales of substantial portions of corporate assets, should be clearly articulated and disclosed so that investors understand their rights and recourse. Transactions should occur at transparent prices and under fair conditions that protect the rights of all shareholders according to their class. 2) Anti-takeover devices should not be used to shield management from accountability.”
According to the Securities Market Act (SMA), a person who has gained dominant influence over a target issuer, directly or together with other people acting in concert, is required to make a takeover bid for all shares of the target issues with a duration of at least twenty-eight days within twenty days of gaining dominant position.
The FSA has the right to determine the gaining, holding, transfer, absence and scope of dominant influence in each individual case by carefully considering all the relevant circumstances.
In addition, the Estonian Securities Market Act requires that a shareholder or shareholders acting in concert disclose ownership exceeding 1/20, 1/10, 1/5, 1/3, 1/2 or 2/3 of all votes within four trading days to inform the issuer of the number of shares belonging to him/her. The law also stipulates that if this proportion decreases, this will also need to be disclosed to the issuer. The issuer is then required to disclose this information (unless the FSA has first).
The Commercial Code allows a major shareholder or major shareholders to take over a company. In a listed company, when a person acting individually or in concert obtains at least 90 per cent of the voting rights in a company, a squeeze out is approved by the general meeting if 95 per cent of the votes represented are in favour. Furthermore, a person who has gained a controlling influence over the company directly or together with other persons acting in concert is required to make a takeover bid for all shares of the company within 20 days of gaining the influence. Additionally, shareholders’ agreements may also provide for compulsory share repurchase rules between shareholders.
The Estonian self-assessment states that “generally anti-takeover measures are permitted”, with shareholders free to agree on restrictions on a contractual basis. Nevertheless, restrictions on the transfer of shares such as pre-emption rights and specific consent requirements which could serve as anti-takeover devices are not allowed.
To ensure that management is not shielded from accountability during a takeover bid, the SMA states that members of the management board and supervisory board of the target issuer are required to be guided by the interests of the target issuer and should not hinder the consideration of the takeover bid by target persons. The supervisory board of the target issuer is required to formulate and disclose its opinion regarding the takeover bid.
During the period between the takeover bid and the results of the takeover bid being made public, the management board or supervisory board of the target issuer (management body of target issuer) cannot perform any acts which could cause the failure of the takeover bid, unless the general meeting of the shareholders authorises them as protective measures. The issue of shares which may permanently prevent the offeror from gaining control over the target issuer is also considered to be a protective measure. The management body of a target issuer has the right to invite other persons to make competing takeover bids without this being considered a protective measure. Fair price of a share in a takeover bid is the highest price that the offeror has to pay for a share within the six months prior to the offer. All provisions in Directive 2004/25/EC on takeover bids have been transposed to Estonian law.
Principle II.F states that “The exercise of ownership rights by all shareholders, including institutional investors, should be facilitated: 1) Institutional investors acting in a fiduciary capacity should disclose their overall corporate governance and voting policies with respect to their investments, including the procedures that they have in place for deciding on the use of their voting rights. 2) Institutional investors acting in a fiduciary capacity should disclose how they manage material conflicts of interest that may affect the exercise of key ownership rights regarding their investments.”
This Principle was deemed broadly implemented in the Estonian self-assessment. However, there are no specific requirements for institutional investors to disclose voting policies, procedures or how they deal with conflicts of interest. The Estonian selfassessment notes that institutional investors must follow the same requirements as all shareholders. As described in the landscape section of this report, investors interviewed suggested that the Estonian listed market is too small to justify special reporting requirements in this regard. While institutional investor shareholdings represent a significant portion of all shares in the Estonian market, many of the larger investors tend to be foreign-based.16 Estonian institutional investors are the minority, with significant equity in very few companies. Thus, there is some risk that such disclosure requirements in relation to such a small market could discourage investor involvement in the market.
Principle II.G states that “Shareholders, including institutional shareholders, should be allowed to consult with each other on issues concerning their basic shareholder rights as defined in the Principles, subject to exceptions to prevent abuse.”
The self assessment states that there are no restrictions in place concerning shareholders’ rights to consult with each other, apart from people acting in concert in the context of a takeover bid. The Estonian Investors Association has facilitated such consultation, but as noted elsewhere, has not been very active in recent years.
Principle III.A (1) states that “All shareholders of the same class should be treated equally. 1) Within any series of class, all shares should carry the same rights. All investors should be able to obtain information about the rights attached to all series and classes of shares before they purchase. Any changes in voting rights should be subject to approval by those classes of shares which are negatively affected.”
The Estonian self assessment views this Principle as having been fully implemented. The Commercial Code (CC) states that “shares with equal nominal values shall grant an equal number of votes”. It also mentions that listed companies should not grant different types of shares any rights which result in unequal treatment of shareholders in voting. Estonian legislation does not allow for golden shares. However, rights attached to shares may be different, for instance in the case of distribution of dividends, but this needs to be clearly stipulated in the articles of association. Some non-voting, dividend-only shares can become voting shares if no dividends are paid for two financial years. They lose their voting rights again on the last day of the financial year during which a dividend is paid in full. The self-assessment stated that companies “may have different types of shares and it may be prescribed by the law or articles of association that the passing of certain resolutions requires the consent of the holders of particular types of shares. This enables the holders of such shares to block respective resolutions.”
The Commercial Code states that the same class of shares may be amended by the resolution of the general meeting by at least a four-fifth majority of votes in favour unless the articles of association prescribe a greater majority. It also dictates that at least nine- tenths of the shareholders whose shares’ rights are being amended must vote in favour of the resolution.
Furthermore, the Law states that the consent of all holders of preferred shares is required in order to adopt resolutions on cancellation or amendment of the preference of preferred shares, or on cancellation of preferred shares.
The Estonian “comply or explain” CG code maintains consistency with these legal requirements by recommending that “under the articles of association of the issuer, it shall not be allowed to grant different types of shares with rights which would result in unequal treatment of shareholders in voting”. Perhaps because this represents a legal requirement that companies must already comply with, none of the listed companies explained anything with respect to this recommendation. This may suggest a need to update the CG code to clarify when its recommendations are legally required and therefore do not require an explanation, and when recommendations go beyond the law and require an additional indication of either compliance or an explanation of why the practice is not followed.
Principle III.A (2) states that “Minority shareholders should be protected from abusive actions by, or in the interest of, controlling shareholders acting either directly or indirectly, and should have effective means of redress.”
The Estonia corporate governance framework provides for some ex-ante mechanisms to prevent the violation of minority shareholders rights. For instance, a resolution on amendments of the articles of association can only be adopted if at least two-thirds of the votes represented at the general meeting are in favour, unless the articles of association prescribe a larger majority. If the company has several classes of shares, a resolution on amendment to the articles of association can be adopted if in addition to the overall two- thirds majority, at least two-thirds of the votes represented at the general meeting of each class of share are in favour, unless the articles of association prescribe otherwise. Furthermore, the management board or the shareholders whose shares represent at least one-tenth of the share capital may demand the inclusion of a certain issue on the agenda. An issue which is initially not on the agenda of a general meeting may be included on the agenda with the consent of at least nine-tenths of the shareholders who participate in the general meeting, if their shares represent at least two-thirds of the share capital.
All shareholders possess the right to information that is set out in the Commercial Code. A shareholder has the right to receive information on the activities of the public limited company from the management board at the general meeting. Nevertheless, the management board may refuse to give information if there is a basis to presume that this may cause significant damage to the interests of the public limited company. If the management board refuses to give information, the shareholder may demand that the general meeting decide on the legality of the shareholder's request or may file within two weeks, a petition to a court in order to obligate the management board to give information.
Shareholders whose shares represent at least one-tenth of the share capital may convene a meeting and place items on the agenda for decision to exercise their rights. The notice of an annual general meeting needs to be given at least three weeks in advance, unless the articles of association prescribe a longer term. For a special general meeting notice at least one week in advance is required unless the articles of association prescribe a longer term.
In addition to this, shareholders possess ex post mechanisms to protect their rights. The Commercial Code allows for the appointment of a special audit at the general meeting of shareholders, by “shareholders whose shares represent at least one-tenth of the share capital”. They may “demand a resolution on conduct of a special audit on matters regarding the management or financial situation of the public limited company, and the appointment of an auditor for the special audit”.
Shareholders can also seek redress through the courts. According to the Bar Association, shareholders do make some use of the courts (mostly lower courts) to enforce corporate governance-related requirements, most often related to annulment of decisions. Nevertheless, official statistics offer little granularity, making it difficult to determine the magnitude of such cases. A 2006 study analysing the effectiveness of redress mechanisms in Estonia carried out by the EBRD concluded that “speed” was an issue, but Estonia fared well in the areas of institutional environment, simplicity and enforceability (Cigna and Enriques, 2006).
Principle III.A (3) states that “Votes should be cast by custodians or nominees in a manner agreed upon with the beneficial owner of the shares.”
The Commercial Code determines the rights attached to shares. These shares grant the shareholder the right to participate in the general meeting of shareholders and in the distribution of profits and, upon dissolution, in the division of the remaining assets of the company. The self assessment states that “as a general rule, rights attached to a book entry security belong to the owner of the securities account to which the security is credited”.
According to the Estonian Central Register of Securities Act, the intermediary is the one entitled to exercise the rights attached to a security credited to a nominee account, but when doing so it has the obligation to follow the instructions of the investor. And as the investor is deemed the owner of the securities in the nominee account, the rights attached to this security belong to the investor.
Estonia enjoys a one-level (end-investor) depository system. Therefore, according to the submitted material, the vast majority of accounts are opened in the name of beneficial owners. Nevertheless, additional information received from Estonia states that “the holdings of foreign investors are still often held on nominee accounts, as it might be more convenient for the holders”. Foreign investors have several options with regards to Estonian equity. They can either open the account directly with Estonian Central Security Depository (ECSD); use the nominee account of an Estonian account operator; or use the nominee account of a foreign account operator of ECSD. Investors in Latvia, Lithuania, Finland and Poland also have the option of having certain Estonian securities also transferred to their accounts in local CSDs (in ECSD they appear on the respective CSD's client account).
As of 1 August 2009, (there were 128 464 active securities accounts opened in the Estonian Central Security Depository. 90 per cent of them were opened for natural persons and 10 per cent for legal persons (71 per cent of these “legal persons” were local private and public limited companies; these also include 1 257 nominee accounts).
The Estonian Central Securities Registry (ECSR) Law allows both the Stock Exchange and Financial Supervisory Authority (FSA) to conduct inquiries into nominee account holders in order to obtain information about the beneficial owners. According to FSA, these nominee accounts for the most part represent too small a proportion of the market to have a significant impact on changes in ownership and control. As a practical matter, FSA has generally been able to determine the beneficial owner when relevant, though this can be more difficult in the case of foreign nominee accounts. The FSA mentioned that there have been two recent cases where it has needed to identify the beneficial owners of shares. One case was domestic, and was solved relatively easily. The other case involving a foreign nominee account has been more difficult and is still pending.
The Securities Market Act states that the holder of a nominee account is required to sign a contract with its clients stating that upon crossing certain ownership thresholds (upwards or downwards), the clients will act according to the requirements set in Estonian laws (regarding reporting, asking permission, etc.). The thresholds are 1/20, 1/10, 1/5, 1/3, 1/2 and 2/3.
Principle III.A (4) states that “Impediments to cross border voting should be eliminated.” There are currently no legal impediments to cross-border voting in Estonia. The Law stipulates that a notice of three weeks should be given for an annual meeting. This could be longer if prescribed in the articles of association. With regards to a special general meeting, a notice of at least one week needs to be given. Furthermore, the notice calling for an annual general meeting is required to set out a list of very specific items.17
The recent amendments to the Commercial Code, allows companies listed on the exchange to facilitate electronic participation in general meetings, without the need to appoint a proxy holder who is physically present at the meeting.
The Corporate Governance code contains a provision which says that “issuers shall make observing and participating in the General meeting possible by means of telecommunication equipment (Internet) if the technical equipment is available and where doing so is not too cost prohibitive for the issuer”. In the summary of companies’ reports on this issue, in 2007 eight issuers announced that this would prove too costly, and after investigation, FSA found that no issuers provided this facility. It remains unclear whether legislative actions to facilitate electronic participation would persuade any companies to adopt such practices, but it will be possible to monitor this through future company reports on their compliance with the CG code.
Principle III.A (5) states that “Processes and procedures for general shareholders meetings should allow for equitable treatment of all shareholders. Company procedures should not make it unduly difficult or expensive to cast votes.”
Under Estonian laws, the shareholders’ meeting is treated as the supreme, managing body of the company. A resolution of the general meeting is adopted if over one-half of the votes represented at the general meeting are in favour (unless the law or the Articles of Association prescribe a greater majority requirement). Exceptions requiring two-thirds or larger majorities have been previously described in relation to Principle III.A (2).
A general meeting is competent to: amend the articles of association; increase and reduce share capital; issue convertible bonds; elect and remove members of the supervisory board; elect an auditor; designate a special audit; approve the annual report and distribute profit; decide on dissolution, merger, division or transformation of the public limited company; decide on conclusion and terms and conditions of transactions with the members of the supervisory board, decide on the conduct of legal disputes with the members of the management board or supervisory board, and appointment of the representative of the public limited company in such transactions and disputes; and decide on other matters placed in the competence of the general meeting by law. A general meeting may adopt resolutions on other matters related to the activities of the public limited company on the demand of the management board or supervisory board. The shareholders are solitarily liable in the same manner as members of the management board or supervisory board for damage caused by resolutions adopted under such conditions.
Discussions with market participants highlighted a case involving Kalev (a company that de-listed in 2009), where an extraordinary shareholders meeting was called on an early Thursday morning at a remote location, making it more difficult for minority shareholders to attend. The controlling shareholder was therefore easily able to meet the 90 per cent threshold of voting capital present to add a significant share transaction to the agenda and approve it. The review team was not able to ascertain whether this represented an isolated case or was an example of more widespread practice.
Recent Commercial Code amendments aimed at facilitating electronic voting cited above (Section 1.2.1 on “Legal framework" and Section 2.1 on “The regulatory framework for corporations") are also relevant to this Principle. The Commercial Code amendments have also strengthened shareholder rights in relation to annual general meetings through provisions such as: requiring the caller of a meeting to prepare a draft resolution for every item on the agenda; shareholders with shares representing 1/20 of the share of capital (for listed companies) are allowed to add items to the agenda if this is submitted 15 days before the date of the general meeting; and the notice calling for a general meeting needs to be published (for listed companies) in “a way that would allow fast access to the notice".
Principle III.B states that insider trading and self-dealing should be prohibited. The Principle pays particular attention to the need for an effective definition of insider trading and similar abusive conduct, as well as the necessity to have an effective enforcement regime to deter and detect such practices. The annotations also highlight the importance of data collection and effective protections for investors against these practices.
The Estonian self-assessment asserts this Principle is “fully implemented". The Securities Markets Act provides a framework for the prohibition of market abuse which includes misuse of insider information,18 and market manipulation.19 SMA provisions on market abuse are based on EU directives (2003/124/EC and 2003/125/EC implementing 2003/6/EC). Furthermore, the Penal Code envisages financial penalties and/or up to three years imprisonment for abusing insider information and market manipulation.
The Estonian Securities Market Act states that insiders must report insider dealing to the Estonian FSA. The Financial Supervision Authority Act provides the legal framework of financial supervision as well as the duties and obligations of the FSA. The Act states that the FSA, among other issues, applies “administrative coercion/sanctions and other measures to protect the interests of clients and investors". Regarding administrative coercion, it can apply corrective measures which include the removal of licenses, misdemeanour/administrative sanctions can involve fines of up to 300 fine units20 (to natural persons), and up to EUR 32 000 for legal persons.
Furthermore, in the event of failure to comply or inappropriate compliance with an administrative act, the upper limit for a penalty payment is, in the case of a natural person up to EUR 1 150 (EEK 18 000) for the first occasion and altogether up to EUR 3 200 for subsequent occasions to enforce the performance of the same obligation and in the case of legal persons.
Given the small size of Estonia’s capital market, the FSA suggested that it is not practical to use automated market surveillance mechanisms, and that it is more efficient for employees of the FSA to monitor the market to track movements that could raise suspicion of insider trading or market manipulation. The greater challenge or difficulty is to prosecute such cases, because of the high level of proof required to prosecute such cases and split in responsibilities between the FSA for administrative violations and the more serious criminal violations related to insider trading that must be referred to the public prosecutor, where there may be a lack of expertise on financial crimes. As noted in the landscape section of this report, the FSA acknowledges that co-ordination difficulties and lack of sanctioning capacity make it more difficult for them to enforce effectively against such market abuse. According to supplementary information provided by the Estonian authorities, the FSA made substantial progress in enforcement against market abuse cases in 2009. The FSA won its first market manipulation case (misdemeanour), a case that went to court, and a second market manipulation case (this time a criminal offence), was prepared in conjunction with the Public Prosecutor’s Office and filed with a criminal court. A third market abuse case involving insider trading was successfully tried in a criminal court, and the defendant was given a fine. Nevertheless, one market participant suggested that profiting from insider trading was very difficult in Estonia because of the lack of actively traded shares that can be subject to such manipulation.
Principle III.C states that “Members of the board and managers should be required to disclose any material interests in transactions or matters affecting the corporation.”
Both the Commercial Code and the Securities Market Act set the rules of how certain transaction are to be approved within a company. According to the Commercial Code the management board is required to act in the best interest of the company, that is in the most “economically purposeful manner”. The CG code also takes into account the need for shareholders to seek redress, as it delineates grounds for filing claims against a corporation, or even against the management board provided certain activities of the management board were not in the best interest of the corporation. The CC states that “transactions which are beyond the scope of everyday economic activities may only be concluded by the management board with the consent of the supervisory board.”
Furthermore, a transaction concluded between a company and a member of the management board is also considered void if is not based on market price of the service, and not consented by the supervisory board. The supervisory board has the right to examine all documents of the company and to audit the accuracy of accounting, the existence of assets and the conformity of the activities of the company with the law, the articles of association and resolutions of the general meeting.
The Estonian Accounting Standard Board’s guidelines provide the definition criteria for related parties. Entities are considered to be related if one party either controls the other party or has significant influence over the business decisions of the other party.
Disclosures on separate transactions with related parties are required for the following parties: a) Parent company (and persons controlling or having significant influence over the parent company); b) Subsidiaries; c) Associates; d) Other undertakings in the same consolidation group (e.g. fellow subsidiaries); e) Management and supervisory boards as well as shareholders who are private persons with a significant ownership except when these persons lack an opportunity to exert significant influence over the entity’s business decisions; f) Close relatives of the persons described in clause d) (including significant others and children) and entities under their control or significant influence.
Related party transactions (RPTs) are regulated in the Accounting Act, the Commercial Code and the Securities Market. Estonian authorities state that “the framework for related party transactions regulations is quite extensive”, and that legislation is “accompanied with up to four levels of oversight: supervisory boards, auditors, FSA for listed companies, and Tax Authorities”. RPTs are audited as any other information in annual reports. As the disclosure requirements are set in the law, it is the duty of the auditor to carry out procedures accordingly to ensure that the annual reports are free from material misstatements. Estonia has no monetary threshold for disclosure of RPTs; it is for the management board to determine what is significant based on materiality considerations, i.e. an item is considered material if its inclusion could influence the business decisions of the users of the financial statement. For listed companies, the Tallinn Stock Exchange provides a definition of “significance” in its listing requirements. It states that “... a transaction of the Issuer or its subsidiary with a connected person is considered significant if the monetary value of the transaction is larger than thirty per cent (30 per cent) of the Issuer’s consolidated equity recorded in the last audited balance sheet. If during the last twelve (12) months more than one transaction has been effected with a single person, or a person or company connected with such person, all transactions shall be summarised in order to determine the significance of a transaction.”
Estonia’s self-assessment suggests that disclosure of related party transactions has never been an issue as companies “often disclose more information” than is required by the Accounting Act or by EASB guidelines. Inadequate and misleading disclosures in the annual report are punishable by fines and/or up to 3 years’ imprisonment, according to the Penal Code.
Listed companies have the obligation to publish information about agreements with related parties immediately, but management board members who cause damage to the company by the violation of their obligations are jointly liable for compensation for the damage caused. The Review Team found that the practice for managers to acquire liability insurance is not widespread. Furthermore, according to the Accounting Act, related party transactions need to be stated in the annual report.
The Accounting Act requires companies to disclose in the notes of annual accounts all significant transactions with management and supervisory board and other related parties including the description, amount of transactions and balances at the balance sheet date. Only significant balances and transactions are disclosed in the annual report. As the law states, it is the responsibility of the management board to organise the accounting of the company, including compiling the annual report, and therefore the decision on the materiality21 of the information falls on the management board. Furthermore, the FSA review all listed companies’ annual reports for fullness and completeness including related party transactions.
Generally, market participants interviewed did not see abusive related party transactions as an important problem in Estonia. The Estonian authorities asserted that transfer pricing rules require that transactions be made at market rates in order to prevent such abuse. Estonian authorities suggested that the Estonian Tax Authority also plays a part in ensuring against abuse of related party transactions, as it has “developed procedures to carry out the oversight on transfer pricing”. Legal compliance and compliance with accounting standards is overseen in the first instance through external auditor review, and at a more general level, through quality control and enforcement measures undertaken by the Estonian Audit Board, as described in Section 3.1 on “The regulatory framework covering disclosure.” The review team was told that “reporting is seen as being transparent” and since the Commercial Register is online and easily accessible, they suggested that it was relatively easy to identify beneficial owners in order to determine when transactions do involve related parties.
The review team could not determine the extent to which abusive related party transactions may actually occur in practice in Estonia. However, if such abuse does emerge as a problem, Estonia should consider strengthening oversight by providing audit committees with responsibilities to review such transactions, and by strengthening the presence and role of independent directors on such committees.