Contributed By TMI Associates
Overview of Recent Trends
The M&A market in Japan continues to be robust. According to Recof, in 2018 the aggregate number of M&A transactions in which Japanese companies were involved was 3,850 (a 26% increase from the previous year), which represents an increase for seven consecutive years and a record high since 2006.
The number of domestic M&A deals in 2018 was 2,814, another record high. The Central Bank of Japan continues its unprecedented quantitative and qualitative easing policy. Consequently, stock prices have been high in the past few years, which in turn has substantially decreased the number of going-private transactions from 96 in 2008 to 31 in 2018. Yet there has been a steady increase in the number of M&A deals involving divestitures by traditional Japanese conglomerates; these companies are actively divesting non-core businesses aiming to focus more on their core businesses and/or to increase their return on equity. Supported by low funding costs and investors looking for a better return in an extreme low interest rate environment, private equity (PE) funds are acting as the key acquirers of these divested businesses. In fact, the number of domestic M&A deals involving PE funds (both domestic funds and global) in 2018 was 750, the largest ever. The Corporate Governance Code (described in more detail below) – updated in June 2018 – will also accelerate this trend.
In 2018, the number of outbound M&A deals also reached a new high for the fifth consecutive year. Led by the acquisition of Shire by Takeda Pharmaceutical, the largest acquisition by a Japanese company in terms of the purchase price (GBP46 billion), the aggregate transaction value of outbound M&A deals has also shown a significant rise, a 154% increase from 2017. More and more Japanese companies lay greater emphasis on expanding their business overseas, due to Japan’s ageing society and declining population, which has put a strain on domestic organic growth.
It would be natural to expect that outbound M&A deals will keep increasing in the mid- to long- term. In fact, several Japanese listed companies have announced in their mid-term business plans that they intend to make significant investments in M&A transactions overseas. At the same time, outbound M&A deals have been challenging for many Japanese companies due to the differences in legal and regulatory frameworks, language and cultural aspects. In this regard, a study group established by the Ministry of Economy, Trade and Industry (Study Group for Japanese Companies’ M&A Overseas) released a report in March 2018 setting out, among others things, material issues that Japanese companies should note in conducting outbound M&A deals, along with case studies. This report may provide guidelines for best practices of, and support their growth through investments in, outbound M&A deals by Japanese companies.
The number of inbound transactions remained steady from 2015-2017, but showed a significant increase in 2018 (259 transactions, a 31% increase from the previous year). Represented by the USD18 billion pending acquisition of Toshiba Memory by Bain Capital and its consortium, international PE funds were quite active in the Japanese M&A market in 2017. Some other high-profile examples include the acquisition of Asatsu-DK, the third largest advertising agency in Japan, by Bain Capital, and the acquisitions of Hitachi Kokusai Electric and Hitachi Koki, subsidiaries of the leading Japanese electronics company Hitachi, by KKR.
Development of the Japanese Investment Environment for Listed Companies in the Past Decade
Lack of Rule of Conduct for Directors under Hard Law
In Japan, directors are not considered to be agents of shareholders; rather, the Companies Act sets out a requirement that directors owe the “duty of care of a prudent manager” to the company which they serve. Within this legal framework, with respect to the relationship between directors and shareholders, directors do not owe any fiduciary or other duties directly to each shareholder, but only an indirect duty to shareholders bypassing any such direct duty in its “duty of care of a prudent manager” to the company.
Incidentally, although there is a strong argument posited by eminent scholars and practitioners that directors owe the duty to maximise interest of shareholders as a whole, to date there has been no precedent where the Supreme Court has identified such a duty, and the rules of conduct applicable to directors in M&A transactions remain ambiguous. Thus, it is usually the case that when a company receives a takeover offer without any prior agreement with the board of directors (whether unsolicited but friendly or hostile at the outset), the directors of the target company take into account the interests of all stakeholders surrounding the company, including those of business partners and employees. Even in a change in a corporate control situation, directors are not expected to act as auctioneers to maximise the acquisition price; rather, they are allowed to take actions to protect the value of the company itself. This attitude is consistent with the expectation or understanding of the general public in Japan, where companies are perceived as ‘public tools', which owe responsibilities to all stakeholders, and are not simply or exclusively the private possession of shareholders.
As a result, Japan has been a very difficult market for a long time for hostile takeovers and activists. There have been only very limited cases where shareholders have brought actions against the directors of companies, rejecting hostile takeovers, offering favourable acquisition prices or proposals from activists seeking to increase the company’s return on equity or increase the efficiencies of businesses.
Development of Soft Law – Adoption of the Corporate Governance Code and Stewardship Code
Corporate Governance Code
With the increasing globalisation of the world economy, the need for rules of conduct of directors of Japanese companies has become apparent. In March 2015, the Tokyo stock exchange (TSE) adopted Japan’s Corporate Governance Code, which took effect in 2015 and was amended in 2018.
Based on five fundamental principles, the Corporate Governance Code sets out more detailed principles and supplementary principles. The Corporate Governance Code adopts a ‘comply or explain’ approach, ie, listed companies are not required to comply strictly with each principle, but they are required to explain the reason when they do not comply with a principle set out in the Code. While the Corporate Governance Code is ‘soft law’ established by the TSE, and it is not legally required to be complied with nor is it currently enforced by the courts, TSE-listed companies are required to comply with the Code to continue their listing on the TSE. As all TSE-listed companies continue to comply with the Code, and this has become an established custom, eventually principles under the Code should be recognised by the courts as rules of conduct applicable to directors of all companies.
While the Corporate Governance Code does not only primarily focus on the responsibility of listed companies and of their directors to their shareholders – it addresses the importance of relationships with all other stakeholders as well – it has significantly increased the awareness of directors’ accountability to shareholders. Moreover, it has had significant influence on the corporate governance of listed companies. For example, the Corporate Governance Code expects all listed companies to elect two or more outside directors. Previously, most Japanese listed companies were sceptical about the role of outside directors. According to statistics published by the TSE, only 54.2% of companies listed on the TSE had one or more outside director(s) in 2013; this has increased to 96.9% (99.6% for First Section-listed companies) in 2017, two years after the Corporate Governance Code took effect.
Another example is the increased accessibility for international investors to shareholders’ meetings. The Corporate Governance Code states that listed companies should prepare a platform to enable shareholders to exercise their voting rights electronically (including the Electronic Voting Platform), and to translate their meeting notices into English. According to a survey for the year ending June 2018 by Shojihomu, 49.3% of companies (of those responding to the survey) used an electromagnetic voting system (a 4% increase from the previous year), and the rate of companies which prepared English convocation notices and posted them on their website continued to increase (a 3.2% increase from the previous year).
As in many other jurisdictions, institutional investors are major players in the Japanese stock markets. Particularly in Japan, there are two streams of investments by governmental organisations in listed companies that have been increasing significantly in recent years:
Traditionally, domestic institutional investors, particularly banks, pension funds, insurance companies and other financial institutions were silent partners of listed companies, and rarely voted against the agendas proposed by the companies.
With the goal of promoting awareness of the fiduciary responsibilities institutional investors owe to their investor clients, and seeking to encourage institutional investors to engage in dialogue with investee companies to enhance their mid- to long-term return on investments, Japan’s Stewardship Code was published in February 2014 by the Council of Experts on the Stewardship Code, a council set up by the Financial Services Agency of Japan and further updated in May 2017.
The Stewardship Code also takes a ‘comply or explain’ approach. It expects institutional investors to voluntarily adopt principles and follow the suggested guidelines proposed in the code, and publicly disclose suggested matters under each principle, which, among other things, includes adopting clear policies on how they fulfil their stewardship responsibilities, adopting policies on proxy voting and disclose their voting activities, and how they monitor investee companies. If there is any principle an institutional investor does not adopt, the Stewardship Code expects the institutional investor to explain its rationale for non-adoption.
The Stewardship Code not only assumes that asset managers will contribute to the enhancement of corporate value of investee companies through day-to-day constructive dialogue, but it also expects the asset owners, eg, pension funds and insurance companies, to be more responsible for the enhancement of the mid- to long-term investment return for their beneficiaries through setting and disclosing their policies on the fulfilment of their own stewardship responsibilities, and monitoring their investments.
Increasing pressures from the market and clients have caused traditional domestic institutional investors to become keenly aware of their responsibilities and their accountability to clients, and this enhanced awareness has changed the voting practices of investors. Many domestic institutional investors (including large life insurance companies who used to be a friendly partner to their investee companies) now carefully consider each agenda item at shareholders’ meetings, and have started voting against a company proposal if they think the proposal or management’s behaviour is not beneficial to increase the mid- to long-term return on their investments. While the code of conduct under the Stewardship Code is addressed to institutional investors and does not bind listed companies directly, it has played a substantial role in enhancing corporate governance of listed companies through the improvement of monitoring corporate activities and results by institutional investor shareholders.
In March 2018, the FSA published a draft guideline for investor and company engagement, which became final and effective in June 2018. This guideline is intended to supplement the Corporate Governance Code and the Stewardship Code, and encourages institutional investors and listed companies to particularly focus on their dialogues with each other.
Unwinding of Cross-shareholdings
Another notable change during the past decade is the substantial decrease of cross-shareholdings among Japanese listed companies. Traditionally, shares in Japanese listed companies were cross-held by their business partners, including their ‘main banks’, who acted as stable and management-friendly shareholders. This system of cross-shareholding weakened market discipline that applied to listed companies and caused inefficiencies in the use of their financial resources.
In 2010, with the aim to indirectly induce listed companies to reduce their cross-shareholdings, a regulation was amended to require listed companies to explicitly disclose in their annual securities reports the amount of shares held in other listed companies and the purpose of such share ownership if the purpose was for a reason other than pure investment.
The Corporate Governance Code has also played a substantial role in unwinding of cross-shareholdings. The code requests listed companies to disclose their policy with respect to cross-shareholdings, and the boards of directors are expected to review the mid- to long-term economic rationale and future outlook of major cross-shareholdings on an annual basis. The update of the Corporate Governance Code requires listed companies to review the purpose of cross-shareholdings and examine whether the risks and benefits of such holdings are in alignment with the cost of capital, and disclose the outcome of such examination.
With the improvement of transparency on cross-shareholdings and increasing pressure from the market, many listed companies have gradually decreased the amount of their cross-shareholdings. Listed companies now have less passive and management-friendly shareholders, and increasingly face the discipline and pressure from the stock market to improve their financial performance.
Implications for Shareholder Activism
Due to the series of reforms implemented in connection with the corporate governance, as described previously, the Japanese stock market today imposes substantially more discipline on listed companies and institutional shareholders compared to a decade ago. As a result, the market environment today offers increased possibilities that a shareholder’s proposal contrary to views of, or in response to, a management proposal may be accepted by a majority of the company’s shareholders.
In fact, there were several, albeit still not many, notable cases indicating the success of shareholder activism in 2017. The first was a successful proxy fight conducted by Leno, an investment company in which other activist funds invest. Leno made a proposal against Kuroda Electric to elect one outside director designated by the funds, which eventually led to a proxy fight lasting two consecutive years. This proposal by Leno was finally approved at Kuroda’s shareholders’ meeting, the second time an activist fund has had its nominee elected as a director (the first being Steel Partners in 2009). Notably, ISS recommended voting in favour of Leno’s director nominee.
Another notable case in 2017 was the tender offer by Panasonic to purchase all of the outstanding shares of Panahome, a Japanese housing development company it did not own (at the time of the offer, Panahome was both a listed company and a subsidiary of Panasonic). Panasonic initially announced in December 2016 that it would be entering into a share exchange agreement with Panahome to acquire 100% ownership. After a strong opposition campaign lead by Oasis Management Company, a Hong Kong-based activist fund, Panasonic decided to terminate the share exchange agreement and instead commenced a tender offer at a 20% higher price than it would have paid in the exchange arrangement in April 2017.
With the growing global trend of shareholder activism and changes in Japan’s market environment, including enhanced corporate governance measures, activist funds are expected to become more active in 2019. This may lead to increased market discipline on listed companies to improve their return on investment.
In November 2018, the METI announced the launch of a new study group, named the Fair M&A Study Group. This study group is expected to discuss, amongst other matters, the best practices in conflict-of-interest M&A transactions in Japan, including management buyouts and squeeze-outs by controlling shareholders by updating the ‘MBO Guidelines’ published in 2007. Unlike in the United States, there is no common understanding of how the ‘duty of loyalty’ concept should be interpreted, nor is it clear how conflict-of-interest transactions should be disciplined in general. Under such circumstances, the MBO Guidelines have presented best practices on management buyout transactions and were also respected in many court precedents. The update by the Fair M&A Study Group aims to reflect the accumulation of legal and practical discussions and the progress of corporate governance reform over the past decade.
Legal Developments in Recent Years
Faster and more cost-efficient process for cash-out transactions
Since 2006, although cash-outs of minority shareholders were legally possible, these transactions required approval at the shareholders’ meeting and in court by implementing class-shares and procedures similar to reverse stock splits. In May 2015, a new process for the cash-out of minority shareholders was introduced. This now enables a shareholder owning 90% or more of the voting rights of a target company – either alone or together with its wholly owned subsidiary, a Special Controlling Shareholder – to compulsorily acquire the shares of the target company held by other shareholders, upon the approval of the board of directors of the target company (the Call Option by Special Controlling Shareholder).
As a result of this amendment, the acquirer can avoid calling a shareholders’ meeting of the target company and seeking court approval for the payment to the minority shareholders. Also, appraisal rights were introduced and applied to reverse stock splits, which enable a reverse stock split to be used as a cash-out method. Although approval at a shareholders’ meeting and of the court are required when a shareholder does not own 90% or more of the target company, reverse stock splits have been increasingly used as a method for cash-outs.
In the vast majority of cash-out transactions of Japanese public companies seeking to acquire 100% of the outstanding shares of the target company, bidders have announced they will exercise the Call Option by Special Controlling Shareholder if they are able to acquire 90% or more of the outstanding shares through a tender offer, and will conduct a reverse stock split if they do not reach that threshold.
Proposed amendment of Companies Act
To further facilitate the reform on corporate governance, the Ministry of the Justice published its proposal to amend the Companies Act in January 2019 (amendment proposal). The amendment proposal aims to further promote the reform of corporate governance of listed companies initiated by the Corporate Governance Code, as well as those of large private companies that are not subject to stock exchanges’ rules.
The amendment proposal mandates all listed companies to:
The amendment proposal also requires listed companies to make efforts to disclose reference materials to the convocation notice via online by no later than three weeks before the date of shareholders’ meetings (where the current Companies Act only requires to dispatch those materials two weeks before the date of shareholders’ meeting), so that investors will have longer time to consider the agenda of the meeting.
The bill to amend the Companies Act is expected to be presented to the Diet in the second half of 2019 or thereafter.
Proposed amendment of Companies Act and tax reform to facilitate the use of share consideration
In Japan, although tender offer rules allow the use of shares as consideration, in practice, the consideration offered for almost all tender offers is cash, because of a combination of the potential directors’ liabilities in such a transaction, the necessity of court approval for in-kind contributions under the Companies Act and the tax treatment applied (capital gain tax is imposed on the selling shareholders, and carrying over is not allowed). Although the Companies Act issues could be avoided even under current law, by obtaining certain approval from the applicable Japanese ministry under the Act on Strengthening Industrial Competitiveness, shares were never used as consideration for tender offers, because of the tax treatment.
The amendment proposal includes an amendment to grant exemption to the in-kind contribution rule whenever a Japanese stock company uses its own shares as consideration to acquire more than 50% of another stock corporation’s (including non-Japanese companies equivalent to Japanese stock corporations) voting shares (stock distribution).
Additionally, a proposed amendment to the tax code is expected to permit any capital gain arising from the sale of shares (including but not limited to sales through tender offers) meeting certain conditions to be carried over, whenever approval of the applicable Japanese ministry to the underlying transaction is obtained pursuant to the Act on Strengthening Industrial Competitiveness. If this tax reform comes into effect and is extended to a stock distribution transaction, share consideration may become a more practical method for acquisitions of public companies through tender offers as well as of private companies, as in many other jurisdictions.
In particular, under the rules for a stock distribution, although the purchaser and issuing company need to be a Japanese stock corporation, the target company does not necessarily need to be one, and it could be a company incorporated outside Japan, provided the target company is the equivalent of a Japanese stock corporation. Therefore, once the stock distribution process is introduced in the Companies Act and the tax code is amended, we expect M&A deals utilising shares as consideration (including tender offers and outbound deals) to increase.