Aaron Benjamins in Riga -

November marked four years since the collapse of Latvia's then second-biggest bank Parex, an event that pulled the country deeper into the global financial crisis and nearly bankrupted its banking system. But even as the country's banking sector recovers and economic growth in 2012 looks as though it will top 5%, the fastest in Europe, Parex's former minority shareholders aren't celebrating.

Danske Capital, Firebird Management, KJK Capital and East Capital, who collectively have nearly €100bn in assets under management, together owned over 8% of Parex before its implosion. And like the bank's other minority investors, they lost out when the bank was effectively nationalised in 2009. But now they say the Latvian government is endangering its own reputation among international portfolio investors by refusing to compensate such shareholders, who claim the state illegally diluted their shareholdings and expropriated private property by transferring Parex's healthy assets into a "good" bank founded in 2010 called Citadele.

After Parex collapsed in November 2008, the government intervened to prevent a systemic bank failure, ultimately buying 85% of the shares from the major shareholders for a nominal 1 lat. In 2009-2010, the bank's share capital was raised, while many of the remaining healthy assets were transferred out of Parex into the newly created Citadele, in which the minority investors held no shares, but the state holds 75% and the European Bank for Reconstruction and Development (EBRD) 25%.

Citadele has continued to develop its commercial banking operations and finally returned to profitability this year. Parex, on the other hand, lost its banking license and continued to hold the toxic assets. Its name was changed to Reverta, and its sole business activity for the past few years has been to try to recover as much as it can from the non-performing loans it's still lumbered with.

According to the minority investors, this state-led split of Parex into a "good" bank and a "bad" bank, leaving the minority investors in the bad bank, was unfair. "They left us in Parex bank and transferred all of the good assets out without any permission from us. It was an expropriation by the state," argues Antti Partanen, a senior fund manager at Danske Capital, which together with Firebird owned Parex shares through their jointly managed private equity fund, Amber Trust.

Now the investors have given the Latvian government an ultimatum - give up shares in Citadele or face international arbitration. "We are still talking with the government, but we are ready to move into international arbitration in Stockholm at any time," Partanen says.

He warns that the investors would immediately launch arbitration proceedings if the government tries to sell Citadele - the ultimate goal of the state. "Our shareholding in Citadele, after the dilution, is 2.36%; if they sell the bank, then there will be no more point talking and we will go to Stockholm."

The Latvian government needs to take notice, the investors argue, because the bad publicity associated with court proceedings could scare off future investors, such as those the state hopes will participate in the coming yen bond issue. This could, among other things, raise the borrowing costs of a country that is already considered a worse place to invest than its Baltic neighbours Estonia and Lithuania, they say. "There is a reason the daily volumes on the Tallinn board of the [Nasdaq OMX stock market] are ten-times higher than in Riga, despite being a smaller country," says Kustaa Aima, a partner of KJK Capital, another minority investor in Parex. "Equity investors have not put in a large amount in Latvia compared to elsewhere. The allocations to Latvia are going to be smaller and smaller - they need to be more dedicated at attracting portfolio equity investors."

Harvey Sawikin, co-founder of Firebird Management, which has some $1.25bn in assets under management dedicated to Central and Eastern Europe, says he is unhappy with regulation and the judicial system in Latvia. "It's not the first time we have been screwed," he complains. "We have got to the point where we thought we weren't wanted there."

The real losers

Vladimir Loginovs of the Latvian Privatization Agency, the state body that currently holds the government's 75% stake in Citadele, disagrees that investors are shunning his country because of a bad reputation among portfolio investors. Moral hazard, he says, is the government's key concern - the investors simply made a bad investment choice, and they, not Latvian taxpayers, should bear the cost of that. "Instead, we are seeing that they are going after the deep pocket of the state. They know we don't want to have a scandal, so they are using blackmail for this," he says.

He points out that the state still has around LVL700m (around €1bn) invested in the bad bank Reverta and Citadele, and that it will likely lose much of this. "We know for sure LVL200m in Reverta is lost. I don't like the argument [posed by the minority investors] that the state ripped them off and we are now enjoying life. I think the taxpayers of this country will ultimately pay much more than those funds."

He also dismisses the investors' charge that the government illegally transferred assets from Parex into Citadele. "The split and transfers were made at fair value and in accordance with the laws, and with the full knowledge and approval of the European Commission," he says.

But he acknowledges that the Latvian government is in a difficult position. It needs to sell Citadele as part of its bailout agreement with the International Monetary Fund (IMF) and the bank rescue agreement with the European Commission. Previous efforts by advisor Nomura Securities to find a buyer failed last year. Now, Loginovs says, a partial sale via an IPO on the Riga bourse is one of the options being considered - but the minority investors are a big obstacle to this. "Even a small tranche of LVL25m-40m would be hard for the market to absorb, so yes we need every investor," he says.

He points out that the funds complaining over the Parex collapse are exactly the sort needed - smaller ones focused on the region. "I think an offering of a stake in Citadele would be off the radar of bigger funds managing money in London or New York," he says. "We want to have good relations with these investors, but at the same time the Latvian government does not respond to blackmail, and it does not give out shares in Citadele Bank for free. If they want shares in Citadele, we are willing to discuss selling them shares."

In response, Danske Capital's Partanen asks rhetorically: "Why should we pay for shares that we already own?"

In court

The investors have already been to court over the matter. They claim they won in a judgment last October in Latvia's Constitutional Court, which ruled that the method used by the state to increase the share capital in Parex without permission from minority shareholders was unconstitutional. Yet the court did not order any compensation for the investors. "It wasn't retroactive, so [the decision] didn't help us, but it could help us in any future arbitration proceedings," Partanen says.

More recent litigation over the sale of Parex's Belarus leasing company may also help in arbitration proceedings, he says, by helping in the discovery of new evidence.

The arbitration in Stockholm would focus less on the alleged share dilution, and more on what the investors claim was an illegal transfer of assets out of Parex and into Citadele, Partanen says. "It was theft by the state, which is in contravention of bilateral investment treaties signed by the Latvian government."

Loginov says the method the state used to increase the share capital of Parex won't be used in future. But despite the decision of the Constitutional Court, he still rejects the claims of the investors.