Kayo Takigawa and Mikiharu Mori of our law firm, Nagashima Ohno & Tsunematsu, provided an overview of Japanese management buyouts (MBO) in an article in a special supplement to the January 2007 issue of the International Financial Law Review. Since then, the number of MBOs targeting Japanese companies has increased greatly and this has been accompanied by the bringing of legal challenges by minority shareholders. Such minority shareholders have filed petitions for court determination of the fair price for the fully acquirable class shares because they were dissatisfied with the price offered by the companies in the respective tender offers and subsequent squeeze-out procedures. Such petitions have resulted in a societal view that MBOs are detrimental to the interests of minority shareholders. Moreover, in accordance with the amendments to the Securities and Exchange Law (the SEL), the title of which was changed to the Financial Instruments and Exchange Law (the FIEL), on September 30 2007, enacted on December 13 2006, and the subsequent amendments to the regulations of the Tokyo Stock Exchange, as well as changes in the Corporations Law and tax laws, some of the regulations related to MBOs have changed in the last year. In this connection, the Ministry of Economy, Trade and Industry (METI) has formulated and published the Guidelines on Management Buyouts for the Purposes of Enhancing Corporate Value and Securing Due Process on September 4 2007 (the MBO Guidelines). This article focuses on the two main types of recent changes to Japanese MBOs, concerning squeeze-out procedures and conflict of interest issues, as an update to the matters described in the previous article.

In this article, we technically define MBO as the acquisition of the stock of a listed target company by the current management, which generally secures acquisition financing from private equity funds and/or financial institutions either directly or indirectly through an acquisition vehicle, on the assumption that the management of the target company will continue to keep the business operating. MBOs are generally conducted by the combination of (i) a public tender offer pursuant to the FIEL and (ii) a squeeze-out of the minority shareholders of the target company. The procedure for the squeeze-out of minority shareholders of the target company has been unsettled and the practice has been in flux due to the recent reforms in the tax regulations as described below. Also, in the course of an MBO, the interests of management, as the purchaser of the target's stock, inherently conflicts with the interests of the shareholders of the company, as sellers of the stock. In addition, the management of the company generally has more detailed information concerning the target company than the shareholder, creating an asymmetry in the information known about the company between the purchasers and the sellers of the stock in the MBO transaction. The new legislation has addressed the squeeze-out procedures and the conflict of interest issues presented by MBOs.

Squeezing out minority shareholders

The Commercial Code, which was the primary law governing, among other things, shareholders' rights before the enactment of the Company Law in May 2006, did not have a provision that expressly allowed a majority shareholder to squeeze out minority shareholders by paying them cash for their shares. In this connection, prior to the enactment of the new Company Law, the main method to squeeze-out minority shareholders was to perform a stock-for-stock exchange (kabushiki-kokan) under the Industrial Revitalisation Law. If a revitalisation plan is approved by METI, the majority shareholder is allowed to make cash payments to the minority shareholders and, in exchange for such cash payment, force such minority shareholders to relinquish any shares in the target company after the stock exchange, as set forth in the revitalisation plan regardless of the lack of specific authority in the Commercial Code. However, a major disadvantage of this scheme was the requirement of approval from METI.

Under the Company Law, in a merger by absorption (kyushu-gappei), an absorption-type demerger (kyushu-bunkatsu) or a stock-for-stock exchange, either the surviving company after the merger, the company which succeeds to the target company's business after a demerger, or the company which becomes a parent company to the target company after the stock-for-stock exchange, became able to deliver cash consideration to the shareholders of the company that ceases to exist after the merger, or the company that is demerged, or the company that becomes a wholly-owned subsidiary after the stock-for-stock exchange. Originally, when this additional flexibility in the consideration used to acquire a Japanese company was proposed, many believed that the stock-for-stock exchange for cash consideration would become the predominant method to squeeze-out minority shareholders in an MBO transaction. However, an amendment of the corporate tax laws in October 2006 to add stock-for-stock exchanges to the list of transactions subject to corporate reorganisation taxation has caused such stock-for-stock exchanges for cash consideration to be treated disadvantageously from a tax perspective. By using cash for consideration, the stock-for-stock exchange will be classified as a disqualified stock-for-stock exchange, a taxable transaction that will result in the re-evaluation of certain assets (including goodwill) to the fair-market value and subsequent capital gain taxation imposed on the target company for the increased value of various assets including good will. As a result, stock-for-stock exchanges for cash consideration have rarely been used for the purpose of squeezing out minority shareholders.

Alternatively, a method which combines the issuance of new fully acquirable class shares and the disposition of fractional shares has become the prevailing method to squeeze-out minority shareholders. The specific steps of this method are: (i) after completion of the tender offer, the company amends its articles of incorporation to become "a company issuing class shares" and converts the existing common shares into the fully-acquirable class shares; (ii) the shareholders of the company resolve, in a general shareholders' meeting, to approve the redemption of all of the fully-acquirable class shares by the company in exchange for the issuance of the other class shares to the respective shareholders so that the number of class shares delivered to the minority shareholders becomes a fraction of less than one share; (iii) the company sells the class shares on behalf of the minority shareholders, with the total number of such class shares equivalent to the sum of such fractional shares (fractions of a sum less than one share will be rounded down) with permission by the court pursuant to the Article 234, Section 2 of the Company Law. The proceeds gained as a result of such dispositions are delivered to the minority shareholders.

Another method to conduct the squeeze-out procedures is a combination of the stock-for-stock exchange and the disposition of fractional shares. However, a recent amendment to the instructions issued by the national tax agency and the additional flexibility in the consideration upon the stock-for-stock exchange introduced by the Company Law have caused this alternative method to be at risk of being classified as a disqualified stock-for-stock exchange and resulting in unfavourable tax treatment as discussed above. As a result, the number of transactions utilising such method has decreased.

It should be noted that, neither the Commercial Code, the Company Law nor case precedent provides a clear threshold on the proportion of shares or any such factors required for a majority shareholder to squeeze minority shareholders out for cash consideration. Higher shareholding ratio (such as 90%) by the acquirer as a result of tender offer is considered to be a factor, but not to be the dominant element for evaluating the legality of a squeeze-out procedure. Consequently, all of the types of squeeze-out procedures discussed in this article are subject to certain legal risks. As this article focuses on the prevailing practice in Japan concerning the squeeze-out procedures in light of the recent changes in applicable tax laws, the issues surrounding the legality of the procedures are raised, but they are outside the article's scope.

Conflicts of interest

The Company Law provides that the directors owe fiduciary duties to the company rather than to the shareholders of the company. In this connection, it is unclear whether the directors of the target company are obligated to seek the highest value in a stock transaction, which is only between the shareholders of the target company and the purchaser. In other words, it is not clear whether the directors pursuing an MBO transaction are legally obligated to consider the interests of the shareholders of the target company as sellers under the Company Law. Nevertheless, since maximisation of shareholder value is the primary business principle for a for-profit corporation, it is generally accepted that the director shall have certain obligations to at least balance the common interests of the shareholders against their fiduciary obligations to the company itself. Thus, the directors pursuing MBOs face a conflict of interest between their role as a purchaser and their role on behalf of the sellers of the shares. Further, as mentioned earlier, there is an asymmetry in the information known about the company between the purchasers and the sellers, which heightens the conflict of interest issues presented by an MBO transaction.

Amendments to disclosure obligations

The amendments enacted on December 13 2006 in the SEL and the related cabinet office regulations contain provisions, which were intended to provide more disclosure of information by directors conducting MBO transactions, so that the problems associated with the inherent conflict of interest will be mitigated. There are four main changes applicable to MBO transactions, all of which concern the tender offer registration statement and one of which concerns both the registration statement and the position statements report prepared by the target company (which target companies are now required to file pursuant to the recent amendment to the SEL); all of these regulations are applicable if the tender offer is launched by either of (a) the director of the target company, (b) a certain person or entity that is asked by the directors of the target company to launch the tender offer and interest of which is common with such directors, or (c) parent company of the target company:

1. If the tender offer price is based on a written evaluation obtained from a third party, the offeror is required to attach a copy of such evaluation to the tender offer registration statement.
2. If certain measures to ensure that the tender offer price is fair are taken by the offeror, these measures should be set forth in detail in the tender offer registration statement.
3. The offeror's decision-making process, which led to the decision to undertake the MBO, should be disclosed in detail in the registration statement.
4. If the offeror takes measures to avoid the conflict of interest, these measures should be disclosed in detail in both the registration statement and the position statements report.

Among these changes, the requirement to disclose written evaluation from a third party referenced in item (i) above has been the subject of debate as to its reasonableness and effectiveness. This requirement is understood to have been introduced for the purpose of facilitating the disclosure of business plans or future revenue forecasts used as the basis for the evaluation of the tender offer price by the company that were otherwise not available to the shareholders. Given the prevailing political and social climate related to MBOs, in the absence of other factors, one would expect offerors to obtain written evaluations and disclose such evaluations to help justify the tender offer price. However, empirical evidence demonstrates that only some offerors disclose a third party evaluation in their tender offer registration statement and, presuming compliance with the SEL, this would mean that there are a number of MBO transactions conducted without such written evaluations. On the one hand, an evaluation is generally obtained by the offeror for the purpose of showing that the purchase price is not too expensive, since the private equity funds or other financing sources providing funds to the offeror are generally subject to fiduciary duties and obligated vis-à-vis their limited partners or shareholders not to pay too high a purchase price. As such, the written evaluation is probably not very helpful for the shareholders of the target company to determine whether or not the price is high enough for them to tender their shares in the relevant tender offer. On the other hand, in disclosing the written evaluation the offeror reveals the highest price it would be willing to pay as the tender offer price, and thus, it would be forced into a disadvantageous position when competing with another tender offer from a third party.

The lack of a prevailing practice of obtaining and disclosing third party evaluations by offerors are probably due to these two factors of unfairness both with respect to the shareholder in the evaluation of the bid and to the offeror in the competitive bid process. As such, the new requirement that an offeror disclose any evaluations obtained is neither fair to the offeror or to the shareholders nor effective at addressing the conflict of interest issues that have been discussed. In contrast, companies have consistently obtained a third party evaluation to assess a tender offer bid regardless of any legal requirements to file such evaluation (such evaluation is submitted to Stock Exchange but will not be disclosed to shareholders). This indicates that such formal evaluation obtained by the company is fair, and requiring disclosure of such evaluation would be reasonable. As the interests of the company are aligned with that of the shareholders in evaluating a tender offer bid, such information relating to the company's third party opinion is probably very helpful for the shareholders without having any detrimental impact on the company. Consistent with the intent of the legislature to address the conflict of interest and information asymmetry issues, it may thus be more effective, fair and reasonable to change the relevant regulations so as to require the target company, as opposed to the offeror, to disclose the evaluation report obtained for the purpose of supporting the tender offer.

MBO Guidelines

In addition to the changes to the SEL related to disclosure obligations of the offeror and of the target company in respect of an MBO, the MBO Guidelines published by METI in September 2007 are expected to clarify steps that Japanese directors may take in an MBO given the conflict of interest situation presented. The two main principles in an MBO advocated by the MBO Guidelines are (1) the enhancement of corporate value and (2) the conduct of due process to ensure fairness to and consideration of the interests of the shareholders. In order to realise these principles in an MBO transaction, ample opportunity should be provided for the shareholders to determine whether or not they should submit their shares in the tender offer. Practically speaking, the management should take the following steps to ensure shareholders have enough decision-making opportunity: (a) fairness in the company's internal decision-making process in evaluating the offer and (b) fairness in the tender offer procedures to secure an appropriate tender offer price for the shareholders. Examples of fair procedures in the company's evaluation of the offer include consulting outside officers or having an independent third party committee of the board of directors to determine whether the company is in favour with respect to the relevant MBO transaction, securing approval from all of the members of the board of directors and board of statutory auditors, seeking independent advice from specialists with respect to the decision-making process, and obtaining a written evaluation from an independent third party with respect to the tender offer price. Establishing fair tender offer procedures may involve establishing a comparatively long tender offer bid term and avoiding entering into agreements that may overly restrict contact between the target company and any competitive tender offerors.

While the MBO Guidelines are a non-binding authority, they are expected to provide helpful guidance in establishing fair and reasonable procedures for implementing MBO transactions.

Further discussions

Recently, in an MBO for the acquisition of the shares of Cybird Holdings, the board of Cybird consulted with an independent committee to evaluate the MBO transaction in accordance with the MBO Guidelines. Nonetheless, the minority shareholders of Cybird have apparently become dissatisfied with the tender offer price, and it is expected that they may take action to dispute the tender offer, such as demanding that the company re-purchase the minority shareholders' shares and applying for court determination of a fair price for the fully acquirable class shares. In view of these circumstances, despite the publication of the MBO Guidelines, one might conclude that the fairness of the process of an MBO is not as important as the amount of the tender offer price. Nonetheless, a fair process will probably lead to a higher possibility of resulting in a fair purchase price and thus a fair process is important for protecting the interests of the minority shareholders.

Considering the significance of the purchase price, court determination of the tender offer price may, in fact, be the fairest system for protecting the interest of minority shareholders under the present set of circumstances surrounding MBO transactions. Such a system is, however, sometimes not practically feasible for all MBO transactions given the high costs, especially the costs of obtaining a third party appraiser, for determining the fair value for the shares. In this connection, an important next step may be to reform the third party appraisal system into a more easily accessible system through the court or other proceedings. Of course, such a new system may result in an increase of frivolous or abusive lawsuits by minority shareholders, which is not desirable from the perspective of other shareholders or society generally.

For these reasons, despite the recent legislative and regulatory changes that were implemented, further careful consideration and discussions are required to find a fair process for conducting an MBO transaction.

Authors' biographies

Soichiro Fujiwara Nagashima Ohno & Tsunematsu Soichiro Fujiwara is a partner of Nagashima Ohno & Tsunematsu, one of the largest law firms in Japan. His practice focuses on M&A and technology transactions. He worked at Morrison & Foerster in San Francisco as a visiting international attorney from 2003 to 2004. He graduated in 2003 with an LLM from Columbia Law School. He graduated with an LLB from the University of Tokyo, Department of Law in 1996. He was admitted to practice law in Japan in 1998. A list of his recent major publications is set out below: English: "The ABA Guide to International Business Negotiations", Chapter 29: International Business Negotiations in Japan (second edition 2000) (co-author) Japanese: Advance New Company Law, Shoji Homu (co-author) (second edition 2006) Practice of Legal Due Diligence, Chuokeizai-sha (co-author) (2006) Masanori Tsujikawa Nagashima Ohno & Tsunematsu Masanori Tsujikawa is an associate of Nagashima Ohno & Tsunematsu. His main area of practice is M&A and other corporate transactions. Tsujikawa graduated in 2004 with an LLB from the University of Tokyo, Department of Law, and was admitted to the Bar in Japan in 2006.