After much controversy, it is now possible under Japanese law for a non-Japanese company to use its shares as consideration to acquire a Japanese corporation in a triangular merger. It was originally planned that the legislation making this possible would become effective with the introduction of the new Japanese Companies Act on May 1 2006. But strong opposition from Japanese business groups fearing a foreign invasion by way of hostile takeovers delayed the Act's introduction for one year; this allowed Japanese companies to adopt defensive measures. With battlements fortified, access to Japanese shores was granted to the triangular merger on May 1 2007.

On October 2 2007, the first public deal to use triangular merger methods under the new Companies Act was announced by Citigroup and Nikko Cordial Corporation (NCC). Citigroup will acquire all the remaining issued shares of NCC in exchange for shares of Citigroup.

The new Act

The methods introduced by the Companies Act are not literally triangular. Only two Japanese companies can enter into the merger. But under earlier legislation, only shares in the surviving corporation could be used as merger consideration. In the new Companies Act, any share or other asset can be merger consideration, including shares of foreign corporations. Still, it is not possible for foreign companies to directly merge with Japanese companies or distribute their shares directly to shareholders of Japanese companies.

In a typical structure using this method, a foreign company (parent) wishing to acquire a Japanese company (target) first establishes or acquires a Japanese subsidiary (sub). The sub acquires enough shares in the parent to distribute as merger consideration. The target merges into sub, and parent shares are distributed to shareholders of the target in exchange for target shares.

In this scheme, the sub has to be the surviving entity. All assets and liabilities are transferred from target to sub upon merger. This may increase the costs of the merger if registration is required to transfer assets such as real estate and intellectual property. In addition, few governmental approvals or licences are automatically transferable upon a merger, thus requiring the sub to reapply for them to continue businesses conducted by the target. Although a reverse-triangular merger could be an option under such circumstances, it is not allowed because, under the Companies Act, shares in the parent can be allotted only to shareholders of the merging company, not the surviving company.

As alternative to the triangular merger is the triangular share exchange. Bilateral share exchanges were originally made possible in 1999. But as with mergers, the Companies Act now allows other assets, including shares of the parent, to be used as consideration in share exchanges. In a typical triangular share exchange, the parent sets up or acquires a Japanese sub. The sub acquires enough parent shares to effect the exchange. The sub and target enter into a share exchange agreement so that the sub acquires all target shares; shareholders of the target receive parent shares from the sub in exchange for their target shares. The target survives as an independent company owned by the sub, and no transfer of assets or licences are required. The Citigroup-NCC deal uses this triangular share exchange method.

Structure of Triangular Share Exchange

Procedural requirement

To proceed with a merger or share exchange, the boards of directors of sub and target must approve the merger or share exchange agreement. The agreement must then be approved by a vote of two-thirds of the shareholders of sub and target, who attend the respective shareholders meetings. Japanese business groups unsuccessfully sought to increase the shareholder approval threshold.

If, as in the Citigroup-NCC transaction, the sub has already acquired a majority of shares in the target before entering into a merger or share exchange agreement, the target may need to consider how to protect minority shareholders' interests. In general, controlling shareholders do not owe fiduciary duties to minority shareholders under the Companies Act. It is not likely that minority shareholders could directly sue controlling shareholders for self-dealing in this context. But self-dealing has recently received heightened scrutiny in Japan, particularly in the context of M&A transactions.

Firstly, Japanese securities laws and timely-disclosure guidelines of the Tokyo Stock Exchange (TSE) now require more information about procedures and methods taken to secure transparency and fairness in transactions. Secondly, MBO Guidelines issued by the Ministry of Economy, Trade and Industry (METI Guidelines), which generally focus on management buyouts, state that they are applicable to reorganisations between a controlling shareholder company and a controlled company, as they present conflicts of interest similar to those in management buyouts. A special committee of independent outside directors of NCC was set up for the Citigroup-NCC deal, even though that was not common practice in Japanese M&A deals. This change may have an impact on Japanese M&A in the future.

Taxation

Before the amendments in 2006, there was no taxable gain in respect of the assets of the target upon a share exchange. The 2006 tax revision introduced the concept of the Qualified Share Exchange (QSE) – certain requirements should be met for the share exchange to be tax-free. The QSE requirements were further revised in 2007 in connection with the introduction of the triangular share exchange, to allow parent shares to be used in a QSE.

For a triangular share exchange to be a QSE, it has to do the following. The parent must hold all outstanding shares in the sub before the triangular share exchange, and is expected to hold them afterwards. Only parent shares can be allotted to the shareholders of the target as consideration; no boot is allowed. It must be expected that the sub will continue to hold all outstanding shares in the target after the triangular share exchange. In some circumstances, additional requirements must also be met:

If the sub owns more than 50% but less than 100% of shares in target, it must be expected that, after the triangular share exchange, 80% or more of the employees of the target will continue to work for the target, and the target will continue to operate its main business.

If the sub owns 50% or less of the shares in the target, as well as the requirement above, one of the main businesses of the target has to correlate with any business of the sub. With regard to the target and sub, the amount of the sales, the number of the employees or other similar elements of one party must be less than five times those of the other; or either of the managements of the target – the president, vice-president, the representative directors – must remain in his/her position after the triangular share exchange. Lastly, the shareholders of the target that are expected to continue holding parent shares received as consideration after the triangular share exchange must hold 80% or more of the target's shares; this third item is required only if the target has fewer than 50 shareholders.

Before the 2007 tax law revision, it was not clear to what extent the sub had to operate a business, or how to determine the correlation between the main business of the target and the businesses of the sub (not parent) to satisfy the requirement mentioned above. Especially in a triangular share exchange, this would be a big concern because the parent might want to form a sub solely for purposes of the triangular share exchange. In that event it would not operate any substantial business. The tax revisions made clear that the sub and target basically have to be operating companies or have taken substantial steps toward becoming operating companies; the sub cannot be a shell acquisition vehicle. Regarding the correlation requirement, though, the tax revisions include a presumption of correlation if both sub and target operate their businesses together using their respective business resources after the triangular share exchange.

As discussed above, the parent must hold all outstanding shares in the sub before and after a triangular share exchange, and the sub is expected to hold all outstanding shares in the target after a triangular share exchange. It is impossible to plan to sell shares in the sub or target, or to accept any investment in the sub or target from the third party after a triangular share exchange. Before the 2006 tax revision, the sub could merge into the target after a share exchange, so that the target shares could be owned directly by a parent. But after that revision, such a merger could spoil QSE status because the parent would no longer hold any shares in the sub.

Boot payment

Restrictions on the payment of boot are a particular concern in the context of cashing out fractional shares. Japanese corporations are prohibited from issuing fractional shares under the Companies Act. The Companies Act states that if the consideration to shareholders includes fractions of shares, the issuing entity accumulates and sells those fractions and pays cash in their place. A tax law ruling says that such payments would not constitute boot. But such a ruling does not apply to triangular share exchanges, creating an issue regarding whether a cash-out of fractional shares of the parent would constitute boot. Of course, under the corporate law of the parent's jurisdiction, it may be perfectly feasible to issue fractional shares. But issuing fractional shares in a triangular share exchange does not give a practical solution to the tax issue in Japan because Japanese securities firms and related institutions, such as the Japan Securities Depository Center (JASDEC), a central securities depository in Japan, are not set up to hold or trade fractional shares. It is expected that this boot issue in connection with a cash-out of fractional shares will be legislatively addressed shortly.

Disclosure

Before enacting the Financial Instruments and Exchange Law (FIEL) in September 2007, which replaced the Securities and Exchange Law, no securities registration statement or prospectus was required when issuing shares in a reorganisation, such as a merger or share exchange; only a convocation notice and related materials had to be distributed to shareholders under the Companies Act. The FIEL has broadened registration requirements to include certain reorganisations. In the triangular merger/share exchange structure, the parent has to register its shares under the FIEL when the number of target shareholders is 50 or more; the target shares are registered under Section 4 of the FIEL (that is, target shares are listed on a stock exchange or the target has once made a public offering of its shares); and the parent shares are not registered under Section 4 of FIEL.

Thus, a parent has to register its shares if the target is a listed company and the parent shares are not registered under the FIEL. After registering its shares, the parent must file annual and semi-annual securities reports continuously even if parent shares are not listed on a Japanese securities exchange (unless the number of parent shareholders has been below 300 for five years after registration). Such disclosure obligations could be costly for foreign companies.

If parent shares are not listed on a Japanese stock exchange, they cannot be distributed through JASDEC, making it burdensome for Japanese target shareholders to receive and sell parent shares. When Chugai Pharmaceutical spun off its wholly owned US subsidiary Gen-Probe (expected to be listed on NASDAQ) in 2002, the parties used the Direct Registration System (DRS) of the US Depositary Trust Company. But it was hard to register individual Japanese shareholders with the DRS. Just translating their Japanese names into English proved difficult.

The stock exchange's role

If parent shares are listed on a Japanese stock exchange, it would be possible to use JASDEC. But even in that case, shareholders of the target may have certain problems if they do not set up a foreign securities trading account at a brokerage. Under the rules of self-regulatory organisations (for example, the Japan Securities Dealers Association and stock exchanges, SROs), only customers that open foreign securities trading accounts can trade foreign shares through securities firms and JASDEC. Shareholders of the target that have not opened such accounts cannot receive parent shares in their accounts at securities firms and cannot trade their shares immediately after the effective date of the share exchange. It is difficult for securities firms and parent, since they have to identify shareholders that have not opened such accounts, and to arrange for distribution procedures for such shareholders separately.

Here the Japanese Depositary Receipts (JDRs) could be a solution, since JDRs are not deemed to be foreign securities under the SROs' rules. The parent shares would be issued to the sub or a securities company, and would then be entrusted to a qualified trustee, such as a trust bank in exchange for transferable beneficiary interest certificates. Those certificates would be deemed securities under the FIEL and could be offered to the public and listed on an exchange. Use of JDRs in a triangular share exchange could avoid need of foreign securities trading accounts for receiving and trading the parent's shares. When using JDRs, though, any right attached to the beneficiary interest certificates (voting rights and rights to distribution) must be identical to the entrusted foreign shares to meet necessary requirements under the FIEL. Otherwise, such beneficiary certificates could not be listed on the TSE.

Although it is not easy or cheap to list shares on any Japanese stock exchange, such a listing may make it easier to obtain the approval of the board of directors and shareholders of the target, and to proceed with share distributions by obtaining JASDEC support. In addition, the listing may not create much additional incremental cost if the parent otherwise has to register its shares under the FIEL and comply with continuing reporting obligations. In the Citigroup-NCC deal, Citigroup listed its shares on the TSE before the date of the NCC shareholders' meeting that approved the share exchange agreement.

Even if parent shares have not been listed, a technical listing system of the TSE exists, which could help unlisted foreign shares to be listed on the TSE. Under that system, when a TSE-listed company merges into an unlisted company or becomes a wholly owned subsidiary of an unlisted company through a share exchange, shares in those unlisted companies can be promptly listed on the TSE, unless they are expected to fall within the delisting standards. With the introduction of a triangular merger/share exchange, the technical listing system was expanded to include unlisted shares in the parent in the triangular reorganisation structure.

Amendments to the Companies Act and Japanese tax law have created a realistic possibility of structuring acquisitions of Japanese companies as tax-efficient triangular reorganisations. The triangular share exchange structure may be more useful than a triangular merger taking into consideration the costs associated with registering a transfer of assets or re-applying for necessary governmental approvals or business licences, which could be the case with a triangular merger.

If shares of a non-Japanese company are to be offered as consideration in the triangular reorganisation, serious consideration should be given to listing those shares on a Japanese stock exchange. Such a listing could help gain the approval of target shareholders and simplify share distribution procedures. Those benefits would have to be weighed against the cost of listing and continuing disclosure obligations. A few issues remain unresolved, but these are just the unforeseen glitches that occur with any newly introduced regulatory scheme. It is to be hoped that they will be resolved in an expeditious manner.

Author biographies

Koji Toshima Mori Hamada & Matsumoto Koji Toshima is an attorney with Mori Hamada & Matsumoto. His areas of practice are international and domestic M&A transactions, takeover bids and corporate restructuring. He also has expertise in the equity and debt finance of listed and unlisted companies, including preferred stock, convertible bonds and stock options. Toshima was educated at the University of Tokyo (LLB, 1997) and Columbia Law School (LLM, 2005). He was admitted to the Bar in 2000 in Japan and in 2006 in New York. He worked at Sullivan & Cromwell LLP in New York from 2005 to 2006 and at Tokyo Stock Exchange, from 2006 to 2007. Rintaro Shinohara Mori Hamada & Matsumoto Rintaro Shinohara is an attorney with Mori Hamada Matsumoto. His practice focuses on corporate and financial transactions, particularly M&A and private equity. He joined the firm in 2001. He was admitted to the Bar in 2001 in Japan and in 2007 in New York. He received his LLM from the University of Chicago Law School in 2006 and his LLB from the University of Tokyo in 1999. From 2004 to 2005 he worked as an associate director at the Ministry of Economy, Trade and Industry of Japan, where he helped develop the Corporate Law, the Limited Partnership Act for Investment, the Limited Liability Partnership Act and the Defence Measures against Hostile Takeovers. Between 2006 and 2007 he worked as an international lawyer at Cleary Gottlieb Steen & Hamilton LLP in New York. He is a member of the New York State Bar Association and the Daiichi-Tokyo Bar Association.