While much of the global business community continues to focus its expansion and investment activity on the dynamic growth of the Chinese and Indian economies, another economic success story continues to unfold slightly closer to home. Growth of Central and Eastern European (CEE) economies at rates of 6%-7% per annum may not be quite as remarkable as the double-digit growth rates of the Asian giants, but when considered alongside the further growth potential stemming from accession to the European Union (EU), former Soviet bloc countries are attractive targets for foreign investment.

Foreign investors have recognised this potential and foreign direct investment in the region increased more than threefold in the three years to 2005. In 2005, the total aggregate value of M&A in the region reached $90bn (£45bn), with this figure expected to continue rising as the full effects of EU membership are seen.

With the exception of Russia, where domestic transactions still make up the majority of deals, inward investment dominates the CEE M&A market. There is particular interest in the manufacturing, communications and financial services sectors and the most significant sources of investment are the US, Germany, Austria and the UK. As well as the overall increase in levels of foreign investment, the size of individual deals has increased significantly, with deals for values in excess of £100m no longer uncommon.

Such rapid growth has presented major challenges for all lawyers involved in deals with significant CEE elements, especially those acting for lenders seeking to secure facilities on assets located in CEE countries.

Security regimes

The sophistication of the security regimes in CEE jurisdictions varies widely and lenders rely on their lawyers to give comfort that debts are secured as fully and effectively as possible. Even when all possible steps are taken, however, lenders may have to accept risks that would be unacceptable to them in more developed jurisdictions.

In Bulgaria, one of the strongest forms of security is the going concern pledge (GCP), which is broadly akin to an English law debenture in that it creates a security interest over all the assets of the company granting security. While a lender might take comfort from obtaining such security, this is compromised by two issues – one practical, the other procedural. The practical issue is that for the GCP to be effective, a schedule of all the assets to be pledged must be attached to the pledge document. If deal completion deadlines are short, this can often mean there is insufficient time to compile a schedule of assets pre-completion and the security will not be immediately effective. The procedural issue is that there is an unavoidable delay of up to six weeks between execution of security documents and their perfection by registration.

This is just one example of the heightened security risk that lenders active in the CEE market must be prepared to take. Other examples exist in even the most developed CEE jurisdictions, such as Poland and the Czech Republic.

Registration

While all CEE jurisdictions do now have security registers, some (particularly in the Balkan states) have only been established very recently – the Serbian registration system was set up in 2005, for instance – and so their reliability and the legal consequences of registration may not yet have been fully determined by the relevant courts. In fact, there are certain jurisdictions, including Montenegro and Kosovo, where prudent legal advice dictates that a security-taker cannot rely on the absence of registration as indicating that no opposable charge exists.

Other CEE security systems may be more developed and reliable, but they are often expensive and complicated and may even require court applications before entries on the register can be made. Since the security of a Bulgarian GCP covers different types of assets, it must be registered in several different registers, each covering a different class of assets. The added scope for administrative delay and expense in perfecting security is clear.

Enforcement

In many ways, the most important consideration for lenders is how easily they will be able to enforce the security they have successfully taken if it becomes necessary to do so. A recent study by the European Bank for Reconstruction and Development (EBRD) found a "surprisingly positive overall picture of enforcement in the EBRD countries of operations". Results of the study suggested that in at least nine CEE countries (including key jurisdictions such as the Czech Republic and Hungary) it is possible to recover more than 80% of the market value of assets over which security has been taken within six months of commencement of enforcement proceedings.

One major CEE jurisdiction in which it is particularly difficult to enforce security is Poland, which is criticised in particular for the amount of time enforcement procedure can take. However, this has not prevented an influx of substantial foreign investment in recent years.

Some CEE jurisdictions have specific local law documentation to accelerate the enforcement of security. For example, the Bulgarian GCP (and other Bulgarian security) should be accompanied by promissory notes granted in favour of the lender. These notes give the lender an additional cause of action, which allows direct recourse to the secured assets without the need to go to court first and are an essential part of a Bulgarian security package.

Exchange controls

It is also worth pointing out certain issues which, while not necessarily specific to CEE transactions, do frequently arise in CEE jurisdictions.

Firstly, lenders should be aware of relevant exchange control restrictions. While exchange control is no longer an issue in member countries of the Organisation for Economic Co-operation and Development – such as Poland, the Czech Republic, Slovakia and Hungary – it remains relevant elsewhere in CEE markets, in particular in Russia and former Soviet states. Where exchange control restrictions are an issue, local passport banks may have to be appointed and long delays are almost inevitable.

Another issue of increased significance in CEE jurisdictions is withholding tax. CEE countries have generally entered into fewer double-taxation treaties than countries with more developed economies. As such, lenders and borrowers alike will often be keen for lenders to lend through entities located in favourable tax jurisdictions.

The situation is further complicated by the fact that due to the rapidity of the growth in the CEE markets, CEE lawyers are themselves on a steep learning curve. They are constantly being asked to advise on deal structures and financial products they have not encountered and to devise appropriate security packages. It is understandable that this in itself can sometimes lead to uncertainty, confusion and delay. This is often exemplified in the availability of reliable legal opinions. The uncertainty surrounding fast-developing law in CEE jurisdictions can make it difficult for local lawyers to give the authoritative opinion a lender might reasonably expect from western European lawyers.

Security regimes in CEE jurisdictions will no doubt continue to develop rapidly over the coming decade and beyond. As a result, lenders will gradually become more accustomed to taking security there. In the meantime, however, lenders should be prepared to experience some increased risk, inconvenience and delay if they are to reap the benefits of continued economic growth in the CEE. Equally, lenders' lawyers must be prepared to give their clients the comfort they need to cope with the challenges they will encounter.

Leon Stephenson is a partner and David Brighton an associate at Reed Smith Richards Butler.