On October 2 2007, Citigroup announced that it reached agreement with Nikko Cordial Corporation to acquire, through its direct wholly owned subsidiary Citigroup Japan Holdings, all issued shares of Nikko Cordial not already owned by the latter in exchange for shares of Citigroup; Citigroup had already acquired 68% of Nikko Cordial shares through a tender offer. The deal was widely reported in the press as the first triangular merger ever carried out under Japan's new Corporations Law; it is probably more accurately described as the first major cross-border public triangular merger in Japan

Triangular mergers became possible under new rules that came into effect on May 1 2007. The new rules form part of Japan's new Corporations Law, and represent the latest and probably the most controversial in a series of corporate law reforms aimed at facilitating mergers and acquisitions in Japan, beginning with the introduction of stock swaps (kabushiki kokan) in 1999, and subsequently corporate spin-offs (kaisha bunkatsu) in 2001.

More significantly, particularly from the perspective of cross-border M&A, the new rules represent a major relaxation of restrictions on the types of consideration that can be used in order to implement corporate mergers and reorganisations in Japan. Previously, Japanese law permitted the use of only one type of non-cash consideration, namely shares in the surviving company, for purposes of such transactions. This rule effectively prevented cross-border acquisitions of Japanese corporations using shares issued by foreign corporations as consideration.

Under the new Corporations Law, however, the surviving company in a merger is free to use cash or non-cash consideration, including shares, bonds and share subscription options issued either by the surviving company itself or by its immediate parent company.

Cross-border triangular mergers

Under the new rules, the term "parent company" is not limited to a Japanese company, but may also include a foreign direct parent. Consequently, in effect, the new rules make possible cross-border "triangular mergers" under which a foreign company can acquire a Japanese company by way of a merger between its Japanese subsidiary and the Japanese target company, the Japanese subsidiary using shares issued by its foreign parent as consideration for shares in the Japanese target company (see diagram).

As the above diagram illustrates, the Corporations Law contemplates a merger in which the Japanese subsidiary of the acquiring company is the surviving entity, that is, a transaction analogous to a forward triangular merger under US law. The Corporations Law does not permit a reverse triangular merger, that is, a merger in which the target company is the surviving entity resulting in the target company becoming a wholly owned subsidiary of the foreign parent. In order to effect a merger along these lines, it would generally be necessary to implement a two-step transaction, the first step involving a share exchange along the lines of the Citigroup/Nikko Cordial transaction, followed by a second step involving an ordinary downstream merger of the Japanese subsidiary into the Japanese target company.

Domestic concerns

The introduction of triangular mergers was postponed for one whole year after the Corporations Law came into effect on May 1 2006 in the face of concerns in the Japanese business community that the new rules would trigger a wave of listed company takeovers, including potentially hostile takeovers, by foreign companies. During that period, the Japanese business community, represented by the Japan Business Federation (Nippon Keidanren), lobbied hard for tighter regulation of triangular mergers, including in relation to the requirements for target company shareholder approval and tax relief for target company shareholders.

But just how likely is it that other foreign corporations will follow in Citigroup's footsteps? The balance of this article examines several key issues relevant to this question in light of foreign and Japanese law.

Issue of shares from foreign parent

The precise operation of triangular merger rules under the Japanese Corporations Law has yet to be fully tested. However, the prevailing consensus is that the rules require the foreign parent to issue shares to its Japanese subsidiary for purposes of implementing a triangular merger or share exchange.

A key threshold question therefore is whether the law of the jurisdiction in which the foreign parent is incorporated will permit such a transaction. A brief outline of the position under US, UK and Australian laws follows.

US

In a typical share merger transaction between two US corporations, the merger agreement provides that the parent/acquiring corporation will form a new subsidiary, which will be merged with the target corporation in a reverse triangular merger. Upon completion of the merger, shares of the target corporation are automatically converted by operation of law into shares of the parent/acquiring corporation. As a result of the merger, the target corporation becomes a wholly owned subsidiary of the parent/acquiring corporation, and the former stockholders of the target corporation become stockholders of the parent/acquiring corporation.

The corporation laws of the US do not require that the parent/acquiring corporation issue shares to its acquisition subsidiary as the first step in a merger between the subsidiary and the target company. However, US corporation laws are generally very flexible with respect to the ability of corporations to purchase, hold and dispose of their own shares, either directly or through their subsidiaries. Accordingly, US corporation laws would generally allow a US corporation to acquire a Japanese corporation through a share merger under the new Corporations Law of Japan by issuing shares to its Japanese subsidiary for use by the subsidiary as consideration in its merger with a Japanese target corporation.

UK

The position under UK law, however, is more complex. The UK Companies Act 1985 imposes a general prohibition on a subsidiary being a shareholder of its holding company such that any allotment or transfer of shares in a company to its subsidiary is void. There is, however, an exemption where the subsidiary holds the shares in its parent only as a trustee and neither the parent nor any subsidiary of the parent has any beneficial interest in the shares.

A UK public limited company (plc) wanting to acquire a Japanese company using its shares as consideration would therefore need to ensure that the Japanese subsidiary holds them only as trustee for the benefit of the shareholders of Japanese target company. In these circumstances, the Japanese subsidiary would be the registered legal owner of the consideration shares until the consideration shares were transferred to the shareholders of Japanese target company. However, it is an open question as to whether such an arrangement would satisfy the requirements of the Japanese Corporations Law in relation to the Japanese subsidiary owning or holding the parent/acquiring company's shares for purposes of a triangular merger.

There are additional requirements under UK law that give rise to further complexity and would need to be carefully considered when drafting the merger documentation. For example, UK law also requires that there is no possibility that the merger will not be effected. UK law also generally requires a UK plc issuing shares for non-cash consideration to have the non-cash consideration independently valued by an independent valuer producing a valuation report.

Australia

Similar issues also arise under Australian law. The Australian Corporations Act renders void the issue or transfer of shares of an Australian company to an entity it controls, subject to some exceptions, including a trustee exception similar to the UK exception.

Australian companies often use a specially set up subsidiary as a bidding vehicle in local acquisitions. For a scrip bid (share-for-share offer), these transactions can be structured so that the subsidiary promises to procure the issue of shares in its parent company to the shareholders of the target or the parent company promises to issue shares to the target's shareholders. Such transactions are not void under the Corporations Act because the subsidiary does not hold or own shares in its parent at any point in time.

However, given the technical requirement under Japanese law for the Japanese subsidiary to actually hold or own shares in its parent for purposes of triangular merger with a Japanese target, a transaction involving an Australian parent/acquiring corporation would need to be structured so that the Japanese company holds such shares as trustee for the target's shareholders. Under this arrangement, the Japanese subsidiary would be registered as a shareholder of the Australian parent until such time as the shares are transferred to the Japanese target's shareholders. Whether such an arrangement would work under Japanese law has yet to be tested.

Resale of the foreign parent's shares

Potential resale restrictions under foreign law may also need to be considered at an early stage. A brief outline of the position under US, UK and Australian laws follows.

US

Under the US federal securities laws, resales of securities issued in connection with acquisition transactions must either be registered with the US Securities and Exchange Commission or be made pursuant to an available exemption from registration.

Where the initial issuance of shares by a public US parent/acquiring company in connection with an acquisition of a Japanese target company is registered with the SEC, non-affiliate shareholders of the Japanese target company may generally resell the shares acquired in the merger without restriction on the US securities exchanges and to US purchasers. If, however, the initial issuance of shares by the US parent/acquiring company is not registered with the SEC, the shares issued to the shareholders of the Japanese target company will constitute "restricted securities" and will be subject to resale restrictions under the US federal securities laws. This is the case even where the US parent/acquiring company is a listed public company.

However, the transaction may be structured to provide for SEC registration of the flow back of shares into the US through resales by non-US holders. In addition, holders of unregistered shares are generally entitled to resell the shares in the US markets in accordance with SEC Rule 144, subject to satisfying certain minimum holding period and other requirements (these requirements are under SEC review).

UK

There are no restrictions on resale as such under English law.

Australia

There are resale restrictions under the Australian Corporations Act that might apply to a triangular merger in Japan using shares in an Australian listed company. These rules would need to be considered by the Japanese investor wishing to re-sell the Australian company shares in Australia.

The Corporations Act targets sales that amount to an indirect issue of securities. The provision requires disclosure (delivery of a prospectus) to Australian investors when securities are offered for resale in Australia within 12 months of their issue where the issue of securities was made without disclosure, with the purpose of onselling the securities. These rules potentially may require the Japanese investor to hold the Australian company shares for 12 months prior to reselling them.

Liquidity

The liquidity of the consideration shares will also be a key threshold question in any cross-border triangular merger or share exchange. A key part of this question is whether the shares need to be listed or registered not only in the foreign parent company's home market but also in Japan. Dual listed shares will no doubt be more attractive to Japanese shareholders unfamiliar with or unused to dealing with foreign shares and share markets.

The Tokyo Stock Exchange recently took steps to relax its listing criteria in respect of the minimum number of shareholders and minimum capitalisation for foreign companies listed on certain US and European markets, ostensibly to facilitate cross-border triangular mergers.

Disclosure requirements

Japanese law requires a Japanese target company entering into a cross-border triangular merger or share exchange agreement to disclose a range of information regarding the foreign parent company and the consideration shares offered to its shareholders.

The Japanese target must prepare a "statement of appropriateness" in relation to the consideration shares. If the shares are unlisted, the statement must set out the share valuation methodology. If the shares are listed, the statement must show that the valuation is based on the average closing price of the consideration shares over a period of months prior to merger completion.

The Japanese target must also provide a Japanese translation of the foreign parent's constitution and balance sheets for the most recent five financial years and also information regarding the foreign parent's officers and directors.

A triangular merger involving a Japanese target with more than 50 shareholders will also potentially trigger the requirements for a public offering of securities under the Financial Instruments and Exchange Law. In addition, the foreign parent will also be subject to the continuous disclosure requirements of the FIEL.

The Japanese subsidiary

New tax rules introduced in March and April 2007 provide for deferral of capital gains tax for qualified triangular mergers. Basically, under these rules a qualified triangular merger is one in which the businesses of the merging entities are related. In addition, the Japanese subsidiary must: (i) own or lease a business facility in Japan, (ii) have employees in Japan, and (iii) be engaged in sales, advertising or market research, or have applied for or hold a government licence or intellectual property rights necessary for the business carried on in Japan.

In effect, these rules operate to exclude the use of special purpose vehicles if qualification for capital gains tax deferral is required.

Cross-border non-cash tenders

The Citigroup deal is an example of the use of a triangular merger or share exchange for purposes of converting a majority owned subsidiary into a wholly owned subsidiary rather than for purposes of an outright takeover of a listed Japanese corporation.

In theory, if the requisite shareholder approval (two-thirds majority vote of the target's shareholders) and other requirements are met, it should be possible for a foreign corporation to conduct a non-cash tender offer bid for a listed Japanese target using either a triangular merger or share exchange transaction or a combination of both types of transaction. In practice, however, there are considerable complexities involved in implementing such transactions on either a friendly or hostile basis.

Friendly tenders

In a friendly takeover using a triangular merger, the Japanese target company's board would cause the company to enter into a merger or share exchange agreement and then proceed to obtain the required shareholder approval.

If the consideration shares were listed on a Japanese stock exchange and the transaction were to qualify for capital gains tax deferral under Japanese tax rules, the target company's shareholders might be sufficiently motivated to approve the transaction. Without these conditions, however, the target's shareholders might have little incentive to give up their shares for those issued by a foreign corporation, even if listed on a foreign market.

Hostile tenders

To date, all successful big takeovers of listed companies in Japan have involved negotiations with major shareholders. It remains to be seen whether an unsolicited tender offer, even on a cash basis, would succeed in the absence of such negotiations. A hostile tender offer involving a triangular merger proposal by a Japanese subsidiary of a foreign corporation would involve considerable complexity.

The Japanese subsidiary would first need to acquire enough shares in the Japanese target to submit a merger proposal to the target's board and shareholders and, most likely, institute a proxy battle during which the proposal would be at risk of rival cash offers.

The authors wish to thank Craig Roeder, Chicago, Robert Adam and Tim Gee, London and Ben McLaughlin, Sydney, for their valuable contributions to this article.

Author biographies

Hiroshi Kondo Baker & McKenzie GJBJ Tokyo Aoyama Aoki Koma Law Office (Gaikokuho Joint Enterprise) Hiroshi Kondo is the managing partner at Baker & McKenzie GJBJ Tokyo Aoyama Aoki Koma Law Office (Gaikokuho Joint Enterprise) and focuses his practice on the areas of Mergers and Acquisitions, Private Equity Investment, Corporate/Commercial, and Labour Law. Kondo is the leader of the M&A Practice Group and also heads the Firm's Venture Capital and Private Equity Practice. He has acted as lead counsel for several high profile M&A transactions in Japan in the telecommunications, insurance and retail markets, and has extensive experience in the areas of private equity investment, particularly with MBOs and LBOs, corporate restructuring, securities regulation, anti-monopoly regulation, and labour dispute resolution. He is a member of the Tokyo Bar Association and the Japan Federation of Bar Associations. He is the author of several articles and books including "Post-Merger Integration: Making a Merger Work" (Chuokeizai-Sha, May 2006). Kondo received an LLB from Chuo University in 1981 and an LLM from Harvard Law School in 1991. Kondo teaches leading litigation practice at the Law School of Chuo University. Christopher M Hodgens Baker & McKenzie GJBJ Tokyo Aoyama Aoki Koma Law Office (Gaikokuho Joint Enterprise) Christopher M Hodgens is a partner at Baker & McKenzie GJBJ Tokyo Aoyama Aoki Koma Law Office (Gaikokuho Joint Enterprise) and focuses his practice on the areas of mergers and acquisitions (M&A) and joint ventures, private equity, general corporate law, financial service regulations, and corporate restructuring. Hodgens specialises in cross-border mergers and acquisitions and other corporate transactions. His recent transactions experience includes cross-border acquisitions, disposals and joint ventures in the hotels, M&A advisory, chemicals, retail, insurance and telecommunications industries, and cross-border private equity work. He is fluent in Japanese and recognised as a Foreign Special Member by the Tokyo Bar Association and the Japan Federation of Bar Associations. Hodgens received his BA (Honours) and LLB from Monash University in 1980 and 1994, respectively. Between 1981 and 1983, he attended Tsukuba University as a fellow student (Mombusho). Hodgens is admitted to practice law in Victoria and New South Wales of Australia.