This article appears courtesy of International Financial Law Review

If legislators proposed a reform to restore a level competitive playing field, but then immediately grabbed back 99.8% of it in the fine print and continued discriminating against a section of the market, it would be very difficult to trust them again.

But this is what Japan is poised to do with its foreign direct investment (FDI) policy and its laws governing so-called cross-border stock swaps. It is an exceedingly poor way to attract investment.

It seems a small group of business interests is pressuring Japan's Ministry of Justice (MoJ) to draft the implementing regulations for Japan's new Company Law in a way that would effectively shut out more than 99.8% of foreign public companies from big cross-border mergers executed through stock swaps (technically known as triangular mergers).

In January 2003 prime minister Junichiro Koizumi took the laudable and courageous step of announcing a national goal to double the cumulative base of FDI in Japan over the next five years, from its current level of just over 1% of GNP to a level over 2% (most developed nations in the OECD are in the 20-30% range).

More than two-thirds of FDI-flows into Japan are either M&A deals or follow-on investment. For this reason, the most important policy measure in Koizumi's plan was the liberalization of cross-border stock swaps, a non-hostile transaction requiring approval of the incumbent board of directors. If this measure ends up eviscerated, Japan's FDI policy will be little more than a joke.

The fear of hostile takeovers

Opening the market for cross-border stock-swaps would eliminate the discrimination against foreign companies that has existed since 1999, when domestic companies alone were allowed to do such deals. Most importantly, the ability to do such cross border tax-deferred stock exchanges would make it much easier for fast-growing foreign companies such as those listed on Nasdaq to expand through friendly mergers and acquisitions with Japanese companies. Growth companies need to conserve cash to fund capital expenditures and working capital. Many of them can only consider M&A transactions if they can use their own stock as consideration.

These are exactly the type of foreign investors that Japan needs most. Many of them have no base of operations in Japan, and need one badly. They would be a completely new and incremental source of dedicated FDI to help invigorate Japan's economy and create new jobs on a long-term basis. These are the companies that can confer the most growth to Japanese stockholders, managers, and employees. Why shut them out?

The trouble started last year when businessmen justified the insertion of a broad menu of takeover defence devices in Japan's new Company Law on the grounds that triangular mergers could be used to execute hostile takeovers (in fact, they cannot). The supposed hostile threat that was endlessly highlighted was the foreign one, even though most recent hostile attempts have been by Japanese companies.

The requested defence devices (poison pills, for example) were duly included in the Company Law, which became law in June 2005. Moreover, because of stubborn resistance from some Japanese politicians eager to criticize Koizumi's reform proposals while pleasing senior business executives, implementation of the rules permitting triangular mergers was delayed by a year, "to give Japanese companies time to install takeover defences". But the concept was devoid of any legal logic, because defences against a friendly transaction are unnecessary.

Now it seems there might have been another reason for the one-year delay. Tucked away in Article 309 of the Company Law was a requirement to obtain shareholder approval through an almost unheard-of super-extraordinary resolution (tokushuketsugi) whenever a public Japanese company is being acquired by a company that is offering transfer-restricted stock and the like (in Japanese, joutoseigenkabushiki-tou) as consideration.

In this context, tokushuketsugi effectively means prohibited transaction. For all practical purposes, it is impossible for a public Japanese company to pass such a resolution, because it requires (among other things) that 50% of all shareholders by headcount approve the transaction. Even if one shareholder held 95% of a company's shares and voted for the deal, that shareholder would still be counted as only one head, and would have to track down 50% of all the minority shareholders (who might be unknown or lack forwarding addresses) and persuade them to vote for the transaction. For listed companies in Japan (which have many tiny, inactive shareholders) a tokushuketsugi is such a stringent level of approval that for all practical purposes is impossible to achieve.

The new Company Law mandated the MoJ to craft the technical definition of transfer-restricted stock and the like in the implementing regulations. At first this looked sensible, because the MoJ is only permitted to promulgate regulations that are authorized by law, and the words transfer-restricted stock have a precise legal meaning: shares that cannot be transferred without the board's approval if that is required in a company's Articles of Incorporation. The Articles of most Japanese private companies require such approval, but Japanese publicly listed companies obviously cannot. Given this, the MoJ was logically expected to draft a definition that would focus on identifying the types of foreign company stock that similarly require special board or shareholder approval: namely, private company stocks.

But under political pressure, the MoJ is reportedly considering defining joutoseigenkabushiki-tou as any stock that is not listed on a Japanese exchange, on grounds of investor protection.

A grand total of only 28 foreign companies, mainly financial institutions, are listed on Japanese stock exchanges. So under this definition, deals involving all foreign companies that are traded on other global stock exchanges but not listed in Japan (well over 99% of the total foreign public company universe) would face the impossible barrier of getting super-extraordinary proposals approved for these triangular mergers. Even though the board would like to approve and support a particular deal, as is legally required before it can even be proposed to investors, there will be no realistic chance of ever gaining shareholder approval because of this impossibly high hurdle. Is this liberalization?