This article summarises the state of affairs in Japan with respect to deal protection provisions in M&A transactions involving public companies, such as no-shop clauses that may or may not be backed up by liquidated damages provisions and termination fees.
Historically, it has been quite rare to find any type of deal protection provisions in transaction agreements in Japan, probably due to the fact that, at least until recently, there was not perceived to be any realistic threat of a continuing transaction being disrupted by a third party. It has been common to include exclusivity provisions in an MOU or other preliminary agreement that requires exclusive negotiations for a specified period leading up to execution of a definitive agreement. However, these exclusivity provisions generally contain no specified penalties for breach and would fall away when the definitive agreement is executed.
Whether or not third-party interlopers have become a significant threat, it can no longer be said that there is no perceived threat. The possibility of hostile acquisitions, particularly by foreign acquirers, is a hot topic in Japanese business and legal circles. In recent years, there have been a number of high-profile (though unsuccessful) cases of hostile bids both domestic and foreign such as hostile tender offers by Steel Partners for Bull-Dog Sauce, by Yumeshin Holdings for Japan Engineering Consultants, and by Oji Paper for Hokuetsu Paper Mills; Steel Partners and Yumeshin Holdings failed in their efforts to enjoin defensive measures by the targets. There have also been big changes to Japanese corporate law that have been perceived in the Japanese business community as creating tools that could facilitate hostile takeovers by foreign companies, such as the introduction of provisions permitting triangular mergers and share exchanges. In fact, the perceived threat from these legislative changes was so significant that the effective date of the triangular merger provisions was delayed for a year to give Japanese companies time to enact corporate defences such as poison pills (yet another newfangled concept for Japan).
Seminal "no-shop" case
Notwithstanding all the talk of corporate raiders and foreign encroachment, it is somewhat ironic that the actual transaction that perhaps sent the greatest shock waves and indicated a true shift in corporate culture involved purely homegrown players representing the bedrock of corporate Japan Sumitomo Trust and the financial groups of Toyko-Mitsubishi and UFJ. That transaction involved the negotiated consolidation of the Tokyo-Mitsubishi financial group and the UFJ financial group. However, an MOU had already been entered between UFJ entities and Sumitomo Trust with respect to, among other things, the acquisition by Sumitomo Trust of the trust-related business of UFJ Trust. That MOU contained a no-shop provision that did not include any fiduciary out or any specific payment or remedy for breach. Based on that provision, Sumitomo Trust filed a suit against UFJ entities seeking to enjoin the negotiations between UFJ and Tokyo-Mitsubishi and payment of damages, creating the first test case of the enforceability of a no-shop clause in Japan.
In that case, the claim for injunctive relief went all the way to the Supreme Court, which held that the no-shop clause was valid but declined to grant an injunction on the basis of lack of necessity (Supreme Court decision as of August 30 2004). In that decision, the Supreme Court said that the MOU did not assure the execution of a definitive agreement and that Sumitomo Trust only had an expectation of such execution, meaning that the damage incurred by Sumitomo Trust stemmed from the loss of such expectation. In denying the injunction, the Supreme Court pointed to three factors, including the fact that it was not impossible to recover damages through monetary remedies without an injunction. In this regard, considering that MOUs usually do not assure the execution of a definitive agreement, the Court's decision implies that it may be unlikely to obtain injunctive relief on the basis of a no-shop provision in an MOU.
As to the issue of damages, Sumitomo Trust made a claim in the amount of ¥233.1 billion ($2.1 billion), arguing that because the likelihood of executing a definitive agreement based on the MOU was objectively strong, UFJ's breach of the no-shop provision in the MOU should entitle Sumitomo Trust to damages in the same amount as if UFJ had walked away from the definitive agreement. (The type of damages claimed are called rikou rieki, which are similar to damages based on an expectation interest.) Sumitomo Trust also argued that even if the court did not find a 100% likelihood of execution of a definitive agreement, the amount of damages should be proportional to the likelihood; that is, ¥233.1 billion multiplied by the percentage likelihood of executing the definitive agreement. The Tokyo District Court, as the court of first instance, denied Sumitomo Trust's damages claim (Tokyo District Court decision as of February 13 2006). The case was settled on November 21 2006 for a payment to Sumitomo Trust of ¥2.5 billion while the appeal of the case was pending at the Tokyo High Court.
The Sumitomo-UFJ case has made it clear that no-shop provisions are not invalid as a matter of Japanese law; however, there remain serious questions as to the efficacy of their enforceability. The Supreme Court decision indicates that it would probably be difficult to obtain an injunctive remedy. Although criticised, the Tokyo District Court decision seems to indicate that monetary damages for breach would only be reimbursement of out-of-pocket expenses of the non-breaching party, such as costs incurred for due diligence (so-called shinrai rieki, usually a lower amount, instead of rikou rieki). Some have been led to conclude that a no-shop provision is not meaningful unless accompanied by a provision specifying liquidated damages or a termination fee.
Disclosed deal protection
Given the Sumitomo-UFJ precedent together with the recent concerns over hostile takeovers, it might be expected that meaningful deal protection provisions would have become de rigueur in Japanese M&A transactions. Oddly, that does not yet seem to be the case. A review of public filings has turned up only four public transactions having deal protection provisions that are above and beyond simple no-shop/exclusivity provisions in the pre-definitive-agreement MOU. Where these provisions have been found, they are generally not included in the statutory merger or share exchange agreement that has to be approved by shareholders and usually contains only the minimum provisions required by the Companies Law. Rather they are contained in separate agreements between the parties that generally do not have to be disclosed in their entirety in public filings, at least not under Japanese disclosure rules.
Based on publicly available information, the relatively few deal protection provisions that involve specified remedies take the form of liquidated damages (iyakukin), penalties (iyakubatsu) or termination fees (kaiyakukin), which are slightly different legal concepts under Japanese law. A brief summary of four transactions with publicly disclosed deal protections provisions is set out below.
Tanabe Mitsubishi Pharma
On February 2 2007, Tanabe Seiyaku, Mitsubishi Pharma Corporation and Mitsubishi Chemical Holdings Corporation entered into a basic agreement with respect to a merger between Tanabe and Mitsubishi Pharma that contained the following deal protection features.
No-shop: During the effective period of the basic agreement, Tanabe, Mitsubishi Pharma and Mitsubishi Chemical have an obligation not to discuss or negotiate with any third party in connection with a corporate reorganisation transaction including merger (as set forth in the basic agreement) to which Tanabe or Mitsubishi Pharma is a party.
Parent lock-up: During the effective period of the basic agreement, Mitsubishi Chemical has an obligation not to consummate a corporate reorganisation transaction (as set forth in the basic agreement) that would make it extremely difficult to execute the merger between Tanabe and Mitsubishi Pharma.
Penalty: Tanabe, Mitsubishi Pharma and Mitsubishi Chemical agree that the party breaching these obligations will pay a penalty. However, the amount of the penalty was not disclosed.
Citigroup Nikko Cordial
Before the launch of a tender offer on March 15 2007, by Citigroup Japan Investments LLC for all outstanding shares of Nikko Cordial Corporation, an alliance agreement was entered into on March 6 2007 between the bidder, target and Citigroup Inc that contained the following:
Fiduciary out/no-shop: Nikko agreed not to solicit or engage in negotiations of other offers to acquire stock or assets of Nikko or of certain of its significant subsidiaries for a certain period except in small amounts and other than as required by Japanese law to allow the directors of Nikko to satisfy their duties under Japanese law.
Termination fee: If Nikko wishes to terminate the alliance agreement in accordance with provisions thereof in order to accept a superior proposal or in certain other cases, Nikko is required to pay Citigroup a termination fee of ¥5 billion. That fee represented about 0.5% of the amount equal to the tender offer price of ¥1,700 multiplied by the number of shares tendered (or 0.3% based on the total number of shares for which the offer was made).
Before the commencement of the tender offer on July 3 2007 by Hoya Corporation for all outstanding shares of Pentax Corporation, Hoya and Pentax entered into an agreement on management integration dated May 31 2007 (amended on June 15 2007) containing the following:
No-shop: Hoya and Pentax are prohibited from entering into, executing, proposing or soliciting a capital participation, transfer of all or any assets, offering of shares, transfer of business, merger, corporate demerger, share exchange or stock transfer with any third party that might substantially impede the integration of management between Pentax and Hoya.
Fiduciary out/termination fee: If it is reasonably determined in accordance with due process that the conditions of any third party's proposal are obviously more favourable than those of Hoya, Pentax may cancel the agreement by payment of a termination fee of ¥1 billion to Hoya, which represented about 1% of the transaction value based on the tender offer price multiplied by the number of shares tendered (or 9.95% based on the total number of shares for which the offer was made).
Penalty: If either of Hoya or Pentax (i) breaches the exclusive negotiation duty or certain duties set forth in the agreement during the effective term of the agreement, (ii) executes any contract or other agreement with any third party with respect to a competing transaction on or before the day on which three months has expired after the termination of the agreement (except if such party proves that the competing transaction does not arise from any act of breaching the exclusive negotiation duty set forth in the agreement) or certain other specific events occur, the other party may claim payment of certain expenses and a penalty fee of ¥3 billion, which represents about 3% of the transaction value based on the tender offer price multiplied by the number of shares tendered (or 2.86% based on the total number of shares for which the offer was made).
It is interesting to note that, according to the tender offer materials, before the transaction mentioned above, Pentax and Hoya had entered into a Basic Understanding for Merger dated December 21 2006 that was terminated on May 31 2007 and that contained a provision that had the same content as penalty above.
On June 4 2007, Internet Research Institute, and Orix Corporation entered into a memorandum of understanding with respect to a share exchange between IRI and Orix that contained the following:
No-shop: During the period when the MOU is valid, IRI is obligated not to enter negotiations such as business realignment deals regarding IRI or its subsidiary companies with parties other than Orix.
Liquidated damages: An amount of agreed damages would be payable to Orix for breach of contract where IRI violates the obligations of the memorandum of understanding or can be held responsible for the failure of the integration. However, the amount provided as liquidated damage was not disclosed.
As mentioned above, the Sumitomo-UFJ precedent affirmed the validity of no-shop clauses, but also made clear that they may not have much impact if they do not specify significant monetary remedies. Of course, that raises the issue of whether the specified monetary remedies would be enforceable. As noted above, the rather limited available precedents in the deal protection context provide for a variety of different types of monetary remedies liquidated damages, penalties and termination fees. While there are some court precedents in other contexts, none of these remedies has yet been has been tested in court in an M&A context.
As to liquidated damages, Article 420 of the Civil Code provides that an agreement as to a payment upon breach of an agreement (iyakukin) is presumed to be liquidated damages as compared to a penalty. Article 420(1) of the Civil Code provides that courts may not increase or decrease the agreed amount. However, in practice, courts in some cases have effectively decreased the agreed amount by holding the provision for liquidated damages as being partially invalid on the basis of fairness or public policy, particularly where the agreed amount is significantly in excess of the amount of actual damages. Liquidated damages have also occasionally been held to be invalid in their entirety on the basis of constituting a windfall, or unfair profit. In cases where liquidated damages provisions have been held partially or entirely invalid, courts have looked at various facts, including the amount of actual damages and the purpose of the provision. However, it is difficult to point to a set of clear criteria for predicting when a court will hold a provision as being against fairness or public policy or how a court would determine the appropriate amount of liquidated damages.
As noted, some deal protection precedents have characterised the remedy as a penalty instead of liquidated damages. Under Japanese law, a penalty is not invalid per se and may be treated differently from liquidated damages in certain respects. For example, in case of a penalty, there is some authority that the non-breaching party may require the breaching party to pay not only the penalty, but also actual damages or an amount equal to actual damages minus the penalty, whereas in the case of liquidated damages, the breaching party would only be required to pay the agreed amount of liquidated damages. Thus, there is some basis to conclude that it could be preferable to characterise the stated amount as a penalty (iyakubatsu) instead of liquidated damages (iyakukin). It should be noted, however, that even if the parties characterise the remedy as a penalty, courts may be inclined treat it as a provision for liquidated damages.
One point to note is the potential risk for the directors of a company who approve these types of monetary remedies. If the remedies were deemed excessive, the directors could be found to have breached their duties as directors. Under Japanese law, directors owe a "duty of care as a manager in good faith" (zenkan tsui gimu), which is similar but not identical to the duty of care owed by directors of a US corporation. It is generally said that zenkan tsui gimu subsumes both the duty of loyalty and the duty of care under US law. Courts in Japan use a "business judgment rule" in this connection, although it too is not identical to the standard under US law. Under the business judgment rule in Japan, a court would examine the contents of a transaction without hindsight and give broad discretion to the directors. If directors were found to have breached their duty in approving an excessive liquidated damages provision, for example, the directors would be liable for damages to the company, but the breach by the directors would not in itself invalidate the provision. The provision would only be invalidated based on the fairness-related principles discussed above, although some are arguing that the breach by directors should result in invalidity of the provision giving rise to the breach.
In addition, some have argued that no-shop provisions should be reviewed from the perspective of how to achieve the best interests for shareholders and should be held invalid if they have the effect of coercing shareholders to vote for the transaction. This type of discussion is based on what has been called in Japan the "theory of power allocation between directors and shareholders", which is often referenced in the context of the debate over defensive measures that are taken in response to a threat to corporate control from a hostile bidder. (For example, in the case of mentioned above, Yumeshin unsuccessfully argued that the resolution of directors approving a sock-split as a defensive measure was invalid because it was beyond the director's power.) From this perspective, deal protection provisions set forth in an MOU should be disclosed to shareholders in their entirety if the transaction otherwise requires shareholder approval. As the jurisprudence in this area develops in Japan, it is possible that we will begin to see deal protection provisions being incorporated into the statutory agreements that require shareholder approval, such as merger and share exchange agreements, rather than separate agreements that do not require shareholder approval and may not even need to be fully disclosed.
Mori Hamada & Matsumoto
Hiromi Hayashi is an attorney with Mori Hamada & Matsumoto. Her main areas of practice are international and domestic M&A transactions, corporate restructuring and acquisition financing. She also has expertise in Japanese laws and regulations with respect to the telecommunications business. She was admitted to the bar in 2001 in Japan and in 2007 in New York. She was educated at the University of Tokyo (BS Econ, 1989), the University of Tokyo (LLB, 1997) and Harvard Law School (LLM, 2006). Hayashi worked at Mizuho Corporate Bank (former Industrial Bank of Japan) from 1989 to 1994 and at Davis Polk & Wardwell in New York from 2006 to 2007.