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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.

Deterring the bidder

The advance warning plan specified an extremely long period (90-150 days) for this dysfunctional negotiations and disclosure process. The real purpose of this long period, of course, was to increase the costs and risks to the bidder, in the hope that it would just give up, while giving Yamato as much time as it needed to firm up its support base among shareholders, prepare a strategy to rebut Won Hai's, negotiate with potential white knights, manipulate its share price and shareholder roster, and uncover information that might be useful in labeling Won Hai as an abusive acquiror.

The Chinese company was able to avoid the first trap laid by Yamato's lawyers because it was big enough to finance the entire bid using its own balance sheet. If it had not been, it would have had to disclose plans to use part of Yamato's assets as collateral to refinance its initial acquisition line from the banks. Yamato would have used this to claim that Won Hai was an abusive acquiror as broadly defined in a recent court case.

Yamato reviewed its strategy and concluded there was no need to commence discussions with Meiji as a white knight, because its defences were unassailable. When it thought it had made sufficient preparations and the timing was optimal, it gave 14 day notice of the record date for a shareholder vote.

This sounded fair, except that Won Hai had to fear that Yamato had probably tipped off friendly parties (such as its underwriter and key alliance partners like Fukuoka Metals) to start borrowing stock so that they would be holders over the record date and would control crucial votes. Unlike a straight takeover bid, this was not costly because these firms did not need to purchase the stock, which they could just return the day after the record date. And Won Hai could not fight back in kind, since neither it nor related parties could borrow stock without exceeding the 15% trigger level.

Avoiding blame

Yamato then announced that the shareholder vote would occur in eight weeks, using a written ballot. This avoided a potentially embarrassing physical meeting of shareholders. In the materials it sent out to shareholders, Yamato's board included a one-sided summary of the information that Won Hai had provided, which did not include any of the analysis that shareholders most wanted to see: detail about the projected synergies and economic benefits of the transaction. The board had received such analysis from Won Hai, but was simply not sharing it with shareholders. In the name of facilitating disclosure to shareholders, Yamato's lawyers had actually succeeded in limiting it.

To plead its case, Won Hai had no choice but to hurriedly demand the shareholder list as of the record date, hope that Yamato did not mount a legal challenge to the request, and send out (at huge cost) 320,000 of its own packages describing the benefits of its proposal and the long-term erosion of Yamato's value that was starting to occur without it.

All in vain

But it quickly became obvious that the merits of the case were irrelevant. By substituting a shareholder vote for the straight takeover bid as its preferred battleground, Yamato had made the game virtually unwinnable. The genius of the plan was that gaining approval via shareholder vote to deploy the poison pill could be done with only 50.1% of a quorum, so with the approval of as few as 17% of total voting shares. In contrast, defeating a takeover bid might require convincing 51% of shareholders to not sell for the cash price being offered, which might not be easy if the price was good enough.

Yamato could count on 22% of total potential votes from suppliers, alliance partners, insurance companies and its underwriters and banks – parties under no fiduciary duty constraints, who were loyal to it for giving them business. It seemed that some of these had helped out by borrowing stock equal to another five percent. Historically, only about 55% of Yamato's shareholders had voted in shareholders' meetings, but with a written ballot the voting turnout would tend to be lower for this vote. Moreover, Yamato knew that in corporate Japan's clubby atmosphere, some Japanese investors which might accept Won Hai's bid if things got to that stage, would simply choose to abstain at the shareholder vote stage, fearing embarrassment if they were to appear as non-supporters.

A clever calculation

So Yamato could count on a turnout of less than 50%, of which 27% was already in its pocket. Of course, this calculation was what had dictated the 15% trigger level for the advance notice plan in the first place. In order to be sure of killing all unwanted deals, a trigger of 15% left a comfortable margin of safety; 20% would have been cutting things just a bit close.

The rest was history. Yamato won the vote, the poison pill was issued, and Won Hai gave up. But six months later, Yamato was stunned when Meiji and Won Hai suddenly announced a friendly merger, the joint company using the Japanese firm's stock exchange listing. Meiji's board had dared to analyze the unthinkable. As a result, Meiji's stock price doubled over the next three months, while Yamato's went the other direction. Together, Meiji and Won Hai reaped most of the expected synergies over the next five years, won lots of new business in Asia and stole market share from Yamato.

Yamato received one or two merger inquiries after that, but never anything half as attractive as Won Hai's bid. The best partners all stayed away. His advance warning plan had been all too effective in warning bidders off, President Kanda thought ruefully as he put down the analysts' report.

Nicholas Benes is president of JTP Corporation, an M&A advisory firm, in Tokyo