The number, and the value, of management buyout (MBO) transactions targeting Japanese companies have increased. Front-page MBO transactions include World Co Ltd (an apparel company, acquired for ¥208 billion), Pokka Corporation (a beverage company, acquired for ¥23 billion) and Skylark Co Ltd (a restaurant chain, acquired at about ¥260 billion). Toshiba Ceramics Co Ltd (which makes semiconductor wafers) is also being acquired by its management (for about ¥100 billion yen).

Generally, an MBO is understood as an acquisition of a company by management. The buyout methods vary. They might involve acquiring the business of a target company or buying the stock of the target company. In Japan, a common acquisition strategy these days is to privatize a target listed company after management has acquired its stock (all of the transactions above occurred in this way). The evolution of this transaction-friendly environment has been driven by a number of factors, such as the emergence of a number of funds with fundraising capability, and banks' enhanced acquisition lending capacity. But another reason is that the avoidance of hostile takeovers has become a big concern for management of listed companies, and going private is considered one of the most efficient defences to a hostile takeover.

The legal issues that arise in connection with MBO transactions differ depending on the method employed. The most frequently used structure is the MBO of a listed company that is taken private. A buyout fund, as well as a consortium of lenders, also takes part in the acquisition, usually as a purchaser of the target's stock, because the target's management normally does not have enough resources to purchase the entire company.

Outline of an MBO

First, at the fund providers' (that is, a buyout fund and lenders) request, a due diligence review of the target company is usually conducted. In the course of this review, the target company in making required disclosures should pay attention not to violate applicable laws (such as the Personal Information Protection Law), or confidentiality obligations under agreements it is bound by. Further, assuming that the target company is a listed company, compliance with the insider trading regulations under the Securities and Exchange Law (SE Law) should also be ensured. That is, information regarding the potential MBO should not be leaked to third parties, to prevent insider trading. Also, if the buyout fund (purchaser of stock) discovers any undisclosed material information as defined under the insider trading regulations, the transaction may not take place until the target company makes the information public.

Second, the SE Law, in principle, requires a purchase to be made through a tender offer procedure if the purchase is for more than one-third of the shares of a listed company and is not made through a stock market or exchange. So in most MBO transactions of listed companies a tender offer is necessary. In this regard, there was previously no clear rule on what the extent of and how comprehensive the disclosure of the MBO by the offeror had to be in the course of making a tender offer. However, an amendment to the applicable rules has been announced, and is discussed below.

Third, the step after the stock purchase through a tender offer is to squeeze out the minority shareholders of the target company. This is discussed below.

Fourth, the financing arrangements and shareholders agreement should be carefully considered and prepared. The interests of all relevant parties (management, buyout fund and lenders) should be well coordinated, and an exit strategy for the fund providers should be secured.

In addition, in the course of taking the target company private outlined above, a conflict-of-interest issue concerning the target's management arises. The interests of management as purchasers of the target's stock conflict with that of its shareholders as sellers, although management is obliged to act on behalf of the shareholders.

Tender offer regulations

One of the main issues in an MBO is how much detail the offeror should disclose in making a tender offer, that is, in the tender offer registration statement.

In September 2006, the Financial Services Agency announced a draft amendment to the tender offer regulations under the SE Law (which is expected to be enacted by December 13 2006). The amendment sets out certain rules regarding disclosures in tender offer registration statements when tender offers are made in the course of MBO transactions. The announcement explained that part of the reason for the amendment was to address the conflict-of-interest issues between management and the shareholders. Highlights of the amendment are:

1. The offeror's method of obtaining control or participating in management of the target must be disclosed and the target's management policy or business plan after the transaction must be described. If any event is planned, such as a corporate reorganization or other restructuring, that might have a substantial effect over the target's management policy, the details and necessity of the event should also be disclosed. Also, if the target's stock is expected to be delisted, this expectation and the reasons for it should be explained in detail.
2. How the tender offer price is calculated must be disclosed. If a third party opinion is involved, the third party must be identified. An outline of the opinion and the circumstances in which the tender offer price was determined based on the opinion should be disclosed in detail. Also, if the offeror relies on any other method to ensure that the tender offer price is fair, this method should be disclosed in detail.
3. If the tender offer price is determined based on a written evaluation obtained from a third party, a copy of the evaluation should be attached to the tender offer registration statement.
4. If the offeror and the target's management are in any way related, the offeror's decision-making process employed in respect of the tender offer and any methods for avoiding conflicts of interest, should be disclosed in detail.

The amendment will clarify the disclosure rules for MBOs. But the offeror is now required to meet a higher level of disclosure.

(The discussion above is based on the draft amendment, which may be changed at the time enactment.)

Squeeze out of minority shareholders

The Commercial Code (the primary law governing, among other things, shareholders' rights before the enactment of the new Company Law in May 2006) had no provision that expressly allowed a majority shareholder to squeeze out minority shareholders by paying them cash for their shares. Accordingly, there was a strong argument that cash-outs were not allowed under the Commercial Code, and any squeeze out structured under the Commercial Code risked having its validity successfully challenged.

Because of this argument and consequent risk, take-privates of listed companies were restricted under Japanese law. Technically speaking however, a direct cash-out could still be avoided while squeezing out minority shareholders by combining a stock transfer (kabushiki-iten) or a stock exchange (kabushiki-kokan) with liquidation. This method might still risk being challenged because its only purpose is to squeeze out the minority shareholders by paying them in cash. (The specific steps are: (i) a stock transfer or stock exchange, by which the target company becomes a wholly owned subsidiary of another company (Company X) and the minority shareholders of the target company become shareholders of Company X; (ii) a transfer of shares, by which the shares of the target company are sold from Company X to another entity (in many cases, a special purpose company); and (iii) liquidation, by which Company X is liquidated and the consideration for the shares of the target company is distributed to the shareholders.)

Another squeeze out method is to perform a stock exchange or merger under the Industrial Revitalization Law. Provided a certain revitalization plan is approved by the Ministry of Economy, Trade and Industry, the majority shareholders are allowed to make cash payments to the minority shareholders and (in exchange for such cash payments) force minority shareholders to relinquish any shares in the target company after stock exchange or merger, as provided in the revitalization plan (regardless of the provision under the Commercial Code). One of the disadvantages of this scheme would be that approval by the Ministry of Economy, Trade and Industry is required. However, if the requirements under the Industrial Revitalization Law are satisfied, the risk of a challenge is substantially lower than with other types of squeeze-out transactions.

A recent change in Japan's taxation laws (under which the assets of a company that becomes a subsidiary after a stock transfer or stock exchange are taxed at fair market value) has caused the taxable amount in some stock transfers or stock exchanges to increase, so several recent transactions have employed different approaches, such as setting a share-allotment ratio under which the minority shareholders may only receive fractional shares (allowing the consideration for fractional shares to be paid in cash). This scheme also risks challenge.

However, the restriction on squeeze outs will probably soon fade away. This coming May, the provisions of the new Company Law allowing cash-out mergers will be enacted and it will become easier to validly squeeze out minority shareholders under Japanese law.

Conflicts of interest

In an MBO transaction, management tries to purchase stock from the target's shareholders while it should also be acting for the shareholders' benefit, giving rise to a conflict of interest. Under Japanese law, the traditional concept of a director's conflict of interest usually contemplates a conflict arising between the director and the company in a transaction involving the director and the company. The Company Law provides for certain procedures (such as approval by the board of directors) to be followed in a transaction between the company and one or more of its directors; but no such procedures apply for transactions between shareholders and directors. If a conflict of interest arises between shareholders and directors, the directors could be considered to have an issue concerning their duty of due care. If so, there is no clear rule as to how a director might handle these transactions without violating their duty of due care owed to the shareholders.

Two movements for setting up specific rules for MBO transactions are at various stages of development. One movement will take shape after the amendment of the tender offer regulations, explained above, and the other was described in a report entitled"Corporate Value Report 2006: Toward the Firm Establishment of Fair Rules in the Corporate Community" by the Corporate Value Study Group of the Ministry of Economy, Trade and Industry (March 31 2006).

The Report proposes various protections for shareholders or investors having to decide whether or not a tender offer price is fair, such as making enough disclosure, obtaining an expert's evaluation, securing the objectivity of the decision-making process by having third party reviews, setting the duration of the tender offer period to secure an opportunity for acquisition proposals by third parties, and others. The Report explained that the proposals stem from the inherent conflict of interest between shareholders and management in MBOs and also that shareholders and investors have difficulty in making informed judgments because of an inequality in available information. The Report's proposals are not guaranteed to be drafted into new legislation but the Report might be an indicator of attempts to resolve the conflict-of-interest issue.

More change needed

The air has begun to clear lately, in terms of the legal environment surrounding MBO transactions, especially regarding privatizing a listed company. As long as the economic environment favours them, more MBO transactions are expected to take place. But the relevant regulations still contain many vague points (especially with regard to conflicts of interest), and changes in the regulations as well as ongoing practices should be considered.

Author biographies

Kayo Takigawa Nagashima Ohno & Tsunematsu Kayo Takigawa joined Nagashima Ohno & Tsunematsu in 1997, and has focused her practise on mergers and acquisitions since then. She graduated in 1995 with an LLB from the University of Tokyo, Department of Law, and in 2002 with an LLM from Columbia Law School. She was admitted to practise law in Japan in 1997. Mikiharu Mori Nagashima Ohno & Tsunematsu Mikiharu Mori is an associate of Nagashima Ohno & Tsunematsu. His practice focuses on mergers and acquisitions, including tender offers, MBO (management buyout) transactions and corporate restructurings. He graduated in 2002 with an LLB from the University of Tokyo, Department of Law. He was admitted to the Bar in Japan in 2004.