Japan needs real merger reform and disclosure


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Protectionist business interests risk derailing Japan's merger reforms to allow foreign companies to make non-hostile acquisitions in the country. M&A adviser Nicholas Benes argues that meaningful change is essential if Japan is to raise its woeful levels of foreign investment.

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?

Tilting at the wrong windmill

What makes Article 309 the wrong target for those afraid of the alleged hostile takeover threat, is that it concerns friendly deals. It cannot shut out hostile deals (TOBs), and it cannot shut out cash deals of any type. Thus, so-called vulture funds and domestic Japanese shareholder activists will still be able to freely engage in cash TOBs (to take control of the board first), followed by triangular mergers using cash to take Japanese targets private, without any impossible hurdles to worry about. The investors that will be shut out by Article 309 are those that can add the most value to the Japanese economy: fast-growing, sophisticated strategic acquirers that wish to use their stock.

Ironically, the muddled definition being proposed will not even solve the problem it purports to address, that is, guaranteeing liquidity and investor protection to small shareholders who neglected to vote against the deal. There is no certainty that even those transactions that do not require super-extraordinary approval will result in good liquidity for investors, given the negligible trading volume of many listed stocks in Japan. Then again, for the few tokushuketsugi deals that are approved, there is no certainty that non-voting investors will receive shares that are highly liquid. And if no such transactions are ever approved, there might or might not be good liquidity, but there might also be low value. At any rate, liquidity and value are not ensured by erecting prohibitively high barriers to deals that the board and most shareholders support.

If misguided hardliners are genuinely concerned about liquidity issues in the context of the Company Law, they should be pressuring the MoJ to fortify Japan's appraisal rights system, which allows holders to sell their shares back to the company for fair value. But they are not.

It seems that some Japanese business lobbies want to impose a prohibitively difficult approval standard on triangular mergers with foreign companies so that they need never be expected by their investors to consider such transactions in the first place.

But in that case, the MoJ should not be considering the imposition of a blanket government solution that automatically applies to all firms without shareholder consent. Logically, the Ministry should simply remind each company that under the new Company Law the board will have the flexibility to request approval from its own shareholders to amend the Articles of Incorporation to require a super-extraordinary resolution (tokushuketsugi) to approve selected types of M&A transactions. Each company would even be free to craft its own amendment to add even more potent defences if desired, such as a high approval hurdle for triangular mergers that use cash, which is the real threat (if indeed there is one). At least in this case investors would be consulted in advance.

So then, why are certain interests instead pushing to rewrite law and policy in the fine print of technical rules? Why not just propose amendments of the Articles to their shareholders? One reason is that those interests are not at all confident of getting approval from investors.

Domestic swaps shielded from full disclosure

But there is another reason. While they commandeer the investor protection flag to make triangular merger deals completely unfeasible for strategic foreign investors (often, companies with whom they compete) to propose in the first place, it seems that the same people would also like to avoid more stringent disclosure requirements for their own purely domestic M&A transactions.

Note that the correct legal forum for providing extra protection for investors in Japanese public companies would not normally be the Company Law at all, but rather Japan's securities laws. The Securities and Exchange Law (SEL) is regulated by the Financial Services Agency (FSA), which has announced a renewed reform drive to improve disclosure and enforcement standards. But there are no proposals connecting any of the aforementioned issues with securities laws. The domestic lobby is not demanding that investors be protected by full disclosure under these laws for stock swap, merger, or triangular merger transactions between two domestic companies.

Why not? Because one remaining gap in disclosure under the SEL is for domestic publicly-listed companies' own merger and stock swap transactions that use non-cash consideration. At present, the securities regulations do not require domestic companies participating in such deals to provide the detailed information disclosure that would be sufficient for a "public offering", even though there is usually an issuance of new shares or securities, which should be considered and treated as such according to international best practice disclosure standards.

It is inappropriate (and inconsistent with Japan's commitments to improve corporate governance and investor protection) for business lobbies to demand that the government use the small print of the Company Law regulations to impose a mandatory defensive device that they apparently lack the confidence to request of their own shareholders, while at the same time preserving their own ability to freely engage in domestic transactions without providing adequate securities law disclosure. This is the opposite of investor protection.

As for transactions by foreign companies, disclosure and investor protection could be appropriately ensured by adapting the existing framework for "public offerings without listing" (POWLs, or hijoujou koubo), which are presently allowed under the SEL and Japan Securities Dealer Association rules. This system functions well, having been successfully tapped for a number of large public offerings by issuers such as Bank of China, China Telecom, and Korea Telecom. The disclosure procedures that are already applied in these cases are the most obvious and appropriate standard to be used for triangular mergers.

To allow this, joutoseigenkabushiki-tou should either be defined as what the words literally mean – stock that is under legal restrictions prohibiting valid transfers – or, alternatively, as "securities that will not, as of the time of the proposed transaction, comply with SEL regulations for registration and disclosure".

However, no matter what final definition is crafted, Article 309 will do absolutely nothing to close the hole in SEL regulations and enforcement that presently allows domestic Japanese public companies to avoid providing meaningful securities law disclosure, and associated liability, with respect to stock swaps and triangular mergers. Comprehensive rules under Japan's SEL are urgently needed to treat these transactions as public offerings (kobo), requiring registration and disclosure, regardless of whether the stock used as consideration is foreign or domestic.

It is unfortunately the case that how the MoJ defines an obscure legal term in the new Company Law might determine whether prime minister Koizumi's policies for FDI and investor protection turn out to have real substance, or whether Japan will be viewed as discriminating against foreign companies.

Nicholas Benes is president of JTP Corporation, an investment bank in Tokyo specializing in mergers and acquisitions, and serves on the Japan Investment Council's Experts Committee, which advises the Japanese Cabinet on FDI policy