This article has been written by Anupam Bhaduri pursuing a Diploma in Merger and Acquisitions (PE and VC transactions) from LawSikho.
Japan has been recently regarded as a nation that is making an exceptional boom when it comes to mergers and acquisitions deals. Many believe that long term-demographic and economic shifts that have been enacted are two of the prime reasons behind this boom and this trend is likely to continue. The Japanese have been making amends to their legislations and are focused on their cross border growth. To put it in numbers, the M&A activity in Japan in 2018 was capped at $358.2 billion. This was a surge of 129% from 2017.
Refinitv, formerly known as Thomson Reuters, has been recording the full-year volume of Japanese M&A since 1980 and this is the highest so far. The total number of M&A deals has increased from 3850 in 2018 to 4088 in 2019, making it one of the busiest years. However, what is it that makes Japan a place where investors want to be? Let’s have a look at why this trend happened and why it is here to stay.
Key developments that spurred M&A deals in Japan
Over the years, Japanese policymakers have imbued their business policies and laws with more business rationale to help make Japan a lucrative option for investors across the world. Listed out these changes can be elaborately stated as follows:
Amendment to their Companies Act
The existing Companies Act was completely overhauled in 2006. The resulting enactment was thus new and was done in accordance with the changing times. However, the fast outgrowing business space forced the government to address the shortcomings and thus the first amendment was brought forward in 2014 and came into effect in 2015. This amendment introduced (a) a minority squeeze-out procedure and (b) regulating the issuance of shares with the aim of creating controlling shareholders.
The Ministry of Justice has contemplated more amendments and changes have been made as of the Diet released in December 2019 intended to come into effect sometime before June 2021. This amendment mainly focuses on corporate governance and implements changes like turning most shareholder’s meetings paperless and placing stringent limitations to prevent abusive proposals. The amendment also makes it mandatory for the listed companies to hire at least one outside director. Existing rules regarding director compensation, officers insurance and indemnifications shall be clarified and streamlined in the new amendment. A new reorganisation transaction termed ‘share delivery’ will also be introduced.
This new instrument is essentially a form of stock-for-stock acquisition. The stock-for-stock exchange that is presently available can only be utilised when the acquirer is ready to acquire all the issued shares of the target company. However the acquired can you say share delivery to acquire a part of all issued shares of the target against its own shares. This holds true as long as the target company is not a subsidiary company of the acquirer prior to the acquisition.
The current procedure also requires a court-appointed inspector to verify the value of the shares of the target company prior to the issuance of the acquirer shares. So much so if it is later found that the price of the share of the target company fall short against the price at which the acquirer shares were issued there will be an indemnification to recover the losses incurred. The new amendment will bring forth more options for the acquirer’s to choose from since this is rather burdensome for both parties.
A similar arrangement can also be found in the Act on Strengthening Industrial Competitiveness (ASIC). The process is however regulated in the sense that the acquisition procedure needs to be vetted by the ministry in charge of the relevant industry. While the ‘Share Delivery’ amendment will help merger and acquisition deals skyrocket due to the limited oversight, the ASIC still remains an option available for the companies since this is the only means for Japanese entities participating in cross-border acquisitions. Recenty, Datasection Inc. (Japanese AI company), acquired Jach Technology SpA (Chilean company) through the ASIC mechanism.
The amendments to the Company Act brought in new restructuring options for the squeeze-out and the spin-off transactions. In fact, Koshidaka Holdings Co. LTD completed a spin-off of its subsidiary Curves Holding Co., Ltd., in March 2020, which was the first spin-off compliant with the new tax amendments. Additionally, the amendments have brought in a tax deferral system for stock-for-stock acquisitions approved under the ASIC. Previously this form of exchange and other partial stock-for-stock exchange was unpopular amidst companies and investors due to the taxation regimes on capital gains which will now change thanks to the amendments in play.
Systemic development of their corporate governance
The issue of corporate governance has been a burning issue for the Japanese authorities. A form of stewardship code was introduced in 2014 by the Japanese Financial Services Agencies (referred to as FSA hereon). This code was subsequently revised twice in May 2017 and March 2020. As of now only 281 of the institutional investors have accepted and adopted the measures of the Stewardship Code of 2014. In addition to this, the Stock Exchange of Tokyo’s formulation of the Corporate Governance Code in June 2015, the FSA brought out its Engagement Guidelines (Guidelines for Investor and Company Engagement).
The enactment is meant to establish proper and effective corporate governance for the listed companies of Japan and has a strict vigilance scheme. This code also has important provisions regarding M&A, namely the anti-takeover measures and policy issues that could lead to a change of control or a dilution. The code in itself stresses mid-term or long-term growth and thus it is imperative that the company explains to its shareholders how a proposed M&A transaction would help the company achieve its goals. The remuneration of the directors are also incentivised for long-term performances and Japanese corporations have also taken to restricted stock plans or equity options for their director remunerations.
The rapid growth of enthusiasm regarding long-term incentives have will quickly reflect in cross-border M&A transactions with overseas target companies as well. The further emphasis on the cost of capital implemented through the amendment of the Governance Code introduced in 2018 will drive the Japanese listed companies to focus on their core businesses and ensure that they retain their competitive edge through domestic and international M&A.
Developments in relation to limited subsidiaries
In June 2019, the METI released their “Practical Guidelines for Group Governance Systems”. This legislation discourages the listed companies to maintain subsidiaries which are also listed because this practice creates a conflict of interest between the shareholders of the subsidiary and the main company. The guidelines require the main company to provide a reasonable explanation regarding keeping the subsidiary separately listed while it also encourages the subsidiary to further develop their corporate governance by bringing in independent directors from outside.
Implementation of guidelines like these will increase the chances of the parent company divesting its shares in the subsidiary to a third party or buying out the subsidiary entirely.
The intervention of the Court regarding the fair pricing of deals in M&A
Squeezing-out of minority shareholders is a tricky issue and recently, many minority shareholders have been questioning the squeeze-out price, especially when the acquisition is being done by the management or an acquisition by a controlling shareholder. The Companies Act was apprehensive of this dilemma and thus allows the court to determine a fair price if the minority shareholders dissent to the squeeze-out price.
However, this power is discretionary and the court may set any value given the fact there is no concrete method prescribed on how to reach this value. This uncertainty is a risk that companies have to take into consideration while opting for a squeeze-out and the number of cases where the minority shareholders have challenged the squeeze-out price has increased significantly.
The trend analysis also makes it clear that among other things, the decision of the court in this regard is mainly based on the market price of the shares. This was observed in the cases of Rex Holdings Co., Ltd., Sunstar Inc. and Cybird Holdings Co., Ltd. It is wise to note here that the decrees delivered were on a case-to-case basis and hence determining a common procedure for fixing the ‘fair price’ is difficult.
The determination of a fair price and how it should be done is best dealt with in Jupiter Telecommunications Co., Ltd., case where the apex court of the country overruled the decisions of the lower courts regarding a squeeze-out procedure post-tender offer. The Supreme Court held that the thrust area of focus for the judiciary should be whether the fair procedures were maintained or not rather than determining the fair price in itself.
The Court held that even when there was a significant conflict of interest between the minority and the majority shareholders if the tender offer made was in accordance with the fair practices of the trade, it did not fall within the Court’s purview to determine a fair price in such cases. This was in direct conflict with the previous practice where the court went forward to set the fair price instead of ascertaining fair practice.
The Jupiter case is a landmark case in this regard. The Court outlined that in this particular case, an independent committee was introduced and its opinion was obtained. In addition to this, there was a clear announcement that the squeeze-out price would be the same as the tender offer. This decision has had a significant impact on the M&A trades and lower courts now focus on the actions of the acquirer and whether they align with the fair practices generally accepted in such circumstances.
Resolving of conflict of interest in M&A
METI released the MBO guidelines (Guidelines for Management Buyout to Enhance Corporate Value and Ensure Fair Procedures) back in September 2007 with the aim of formulating a fair path for management buyouts. These guidelines were further reevaluated and thoroughly revised in June 2019 to better reflect the current market practices while METI went on to formulate the Fair M&A Guidelines. This guideline is known for preaching the best alternative solutions to tackle conflict of interest with a focus on management buyouts and acquisitions by controlling shareholder. It should be noted here that the fair guidelines are not binding legislation but a means for the courts to determine whether a trade was carried out keeping into consideration the generally accepted principles.
The fairness guidelines promote that:
- The target company should set up a committee with independent directors and outside independent members,
- Obtain third-party valuations and engage outside legal counsels,
- Maintain a cleaner information disclosure policy,
- Conduct market checks and,
- Adopt conditions like majority-of-minority.
The large-cap deals have adopted the third-party valuations while the fairness guidelines have asserted the presence of the independent committee in negotiations as well. An increase in the number of special committees being formed for the same has been noticed. It is worthwhile here to note that the fairness guidelines have impacted positively especially when it comes to management buyouts.
In order to tackle cases regarding control over the company, the courts have taken resort to a method of determination commonly known as the ‘primary purpose’ test. Through this test, the court tries to determine whether the intention behind the issuance of new shares was to dilute a shareholder and retain control over the management or otherwise.
This is readily available for inspection in the case of Idemitsu Kosan Co., Ltd. (henceforth referred to as Idemitsu) and Showa Shell Sekiyu K.K. merger. Idemitsu is the second-largest petroleum company in Japan. They came to the news when they offered a public offering of its shares. The founding family were unhappy with this and thus filed a petition in order to enjoin the issuance of shares. This happened in light of the fact that the founding family had veto rights that they could use in material corporate actions of Idemitsu. The issuance of new shares would bring the shareholding of the founding family to lesser than one third and the veto rights would be lost as well.
The court in this regard held observed that:
- The issuance of shares was a public offering instead of a private offering to a third party. This meant that the present management of Idemitsu had very little control over who the actual shareholders from the public offering would be.
- Idemitsu already had a bridge loan due within a few months and thus this was the logical course of action.
This case can also sufficiently impact the M&A landscape of Japan with reference to disputes regarding control of a company.
As of present, Japanese companies are taking a significant interest in outbound investments in emerging markets. This aggressive expansion campaign brings with itself the risk of corruption and compliance-related hiccups that can disrupt the M&A space. Due diligence is more important now than ever, especially to ensure that all compliance requirements have been met. The government too has begun to inspect the native companies and foreign entities strictly. A Japanese railway consulting firm and its executives were indicted by the Office of the Tokyo District Public Prosecutor for making illegal payments to officials of Vietnam, Uzbekistan and Indonesia. The Bar Association also published a ‘Guidance on Prevention of Foreign Bribery’ in January 2017 for expansive developments in M&A practise for compliance issues and anti-corruption policies.
Representation and warranties insurance
The usage of representation and usage warranties is more pre-dominant in cross-border M&A rather than domestic M&A. This has been partly true due to the language barrier that comes into play with the insurance companies being unable to ascertain the situation on the basis of due diligence report and transaction files in Japanese. Steps have been taken to mitigate this phenomenon. Insurance executives are becoming more interested in domestic M&A trades because of the abundance of small to midcap acquisitions and mergers owing to natural business succession.
These transactions are characterised by the individual sellers preferring the ‘no-recourse, policy post-sale and the buyers are interested in mitigating the credit risk faced by individual sellers and accommodating the limited recourse options of the sellers. This warranty insurance practices will be a significant market player in recent times given the boom in the M&A practise area.
The major changes enacted by the Japanese government to make the M&A landscape a fairer and quicker place has attracted the attention of the world towards Japan. The industry is booming and right now it is nowhere near stopping. The Japanese have framed an intricate framework that cuts down the bureaucracy and yet manages to implement fairer and wide-reaching disclosure reforms, essentially maintaining a dignified stand against all forms of malice.
- Chapter 30, https://www.amt-law.com/asset/en/pdf/bulletins3_pdf/111129_3.pdf
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