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Japan's new takeover defences are indefensible

The most popular new form of takeover defense in Japan is the so-called advance warning plan. It looks very reasonable and proponents claim it will increase value for shareholders by protecting their interests. In fact, the motivation for many of the plans is killing deals while avoiding director liability. And many of them are carefully designed to entrench any potential mergers, most likely decreasing shareholder value rather than increasing it.

At the end of June 2006 most Japanese companies will hold their annual general meetings. At those meetings many companies will announce advance warning plans or ask shareholders to approve them. It is crucial, therefore, that shareholders be aware of the way these takeover defenses work and their potential implications. To illustrate both of these, here is a fictional story describing how one type of advance warning plan could work in practice.He reflected on what had gone so wrong since the spring day in 2006 when former president Nakamura had directed him to design a takeover defence plan for the company. In those days, Yamato had too much cash and was under pressure from shareholders to either pay it out as dividends or use it to expand via acquisitions. As a result, its stock price was trading lower than the book value per share. Recently, arch-rival Meiji Aluminum and the fast-growing Chinese company Won Hai had both been inquiring about a merger.

The story

It was the year 2012. President Kanda picked up an analysts' report bemoaning the fact that Yamato Aluminum's stock price had lost 60% of its value over the past six years. Revenues and market share had trended down. Average net profits over the six year period were barely positive.

Kanda had analyzed the pros and cons of a merger with Meiji for many years. There would be many synergies and cost reductions, but in any merger with a domestic competitor there were so many overlaps that integration was certain to be painful, especially for the weaker partner, Yamato.

From an economic standpoint, the foreign inquiries (especially Won Hai's) were more compelling: fewer overlaps, more cross-selling opportunities, different technology and process strengths, global informational advantages, and excellent geographic/customer fit.

But these foreign merger alternatives were never analyzed much, because they would end Yamato's way of life as a Japanese organization. That was unthinkable. You do not spend time analyzing something you know you would never want to do. Still, the compelling logic of the foreign mergers made them all the more disturbing.

So Yamato's board had concluded that it needed a takeover defence plan. But it did not want to let in a large number of independent, outside directors who might think differently from it. This left a big problem: because almost all the board members were internal managers who were inherently conflicted, they might be exposed to legal liability on a personal basis if they ever did deploy a poison pill. Thus, the best design for the defence plan would be one that, in the words of president Nakamura, "prevents deals, but avoids all risk of our getting blamed or sued for it."

Sensing lucrative fees, Japan's rapidly emerging defence industry of lawyers and investment bankers leapt to the task. But the advisors were in uncharted waters. No takeover bid (even a friendly one) for a firm with more than 25,000 shareholders had ever succeeded in Japan. There were even logistical problems with the functioning of the takeover bid system when the target had more than that number of investors, a fact that was highly relevant because Yamato had more than 320,000 shareholders.

An insulation plan

But on paper at least, the advance warning plan that the lawyers came up with seemed to insulate the board from embarrassment and legal risk. It did not even require any pesky shareholder approvals, since it was nothing but an advance announcement of the rules of the game as promulgated by management.

On the face of it, the plan sounded so reasonable. Unwanted bidders intending to acquire more than 15% would be required to comply with a detailed list of seemingly reasonable information requests, and if based on that information the board could not devise a legal argument to label the bidder as an abusive acquiror, then the decision to deploy a poison pill would be put to shareholders. Only if shareholders rejected the poison pill could the takeover go ahead unhindered. If, shareholders voted to deploy the pill based on the information provided by management, the directors could not be sued, since they could claim it was shareholders who had so decided.

A year after the plan was announced, it was tested in battle. Won Hai accumulated 14.9% of Yamato's stock and approached management proposing a full merger, with a listing in either Shanghai or Tokyo. Yamato might have saved face if it had chosen the latter, since the deal might look like Yamato had acquired Won Hai rather than the other way around. But Yamato immediately stamped Won Hai's offer as undesirable, not wanting to consider such options and confident that its defence plan would protect it.

Trying to comply

Won Hai complied with Yamato's pre-stipulated rules of the game on disclosure and delivered to Yamato voluminous materials describing its financial position, its future plans for integrating the two firms and how it intended to finance the $8 billion bid. Since all three of Japan's major underwriters refused to cooperate (citing relationships with Yamato), Won Hai worked with a lesser-known financial advisor to prepare the disclosures.

Because of the absence of independent outside directors as a majority on the board, negotiations with Won Hai were dysfunctional, mainly amounting to a search for additional reasons to claim that the deal was not in the best interests of Yamato. This was inevitable, as the board did not even have a minimum price target or requirements above which it believed it bore a fiduciary obligation to negotiate in earnest.