In recent years, Japan has made efforts to amend its corporate laws to meet practical concerns and respond to changes in Japan's social and economic landscapes. To finalize and cap these continued efforts, the Corporate Law (Kaisha-Ho), which reflects all the amendments made and will streamline and replace the rules applied to corporations under the Commercial Code of Japan (Sho-Ho), was enacted in June 2005. The effective date of the Corporate Law (except for certain provisions) is scheduled for May 2006.

Under the Commercial Code, merger consideration delivered to the shareholders of the acquired company (the disappearing company) is, in principle, limited to the shares of the acquiring company (the surviving company).

Under the Corporate Law, it would be possible for the surviving company to deliver surviving company shares, bonds, share purchase warrants (shinkabu-yoyakuken), bonds with share purchase warrants (shinkabu-yoyakuken-tuki-shasai) and/or other assets to the shareholders of the disappearing company. The Corporate Law does not explicitly limit the other assets available as merger consideration. For example, a cash-out merger (in which merger consideration is composed of cash only) and a forward triangular merger (in which merger consideration is composed of the shares of the surviving company's parent) will become available. This amendment gives more flexibility to consideration, and applies not only to mergers but also to certain other types of M&A transactions, such as stock-for-stock exchange (kabushiki-kokan).

The amendment giving more flexibility to the consideration of M&A transactions came about in response to strong requests, from Japan and abroad, to facilitate corporate acquisitions in Japan. A part of the Japanese business community, however, has expressed a strong concern about the potential increase of hostile takeovers of Japanese companies by foreign companies as a result of the amendment. Consequently, the articles of the Corporate Law that give more flexibility to the consideration of M&A transactions will come into effect one year after the effective date of the other parts of the Corporate Law (that is, May 2007).

Legal structure of mergers under the Commercial Code

Under the Commercial Code, after a merger between two companies, the surviving company continues to exist as a legal entity, and the disappearing company ceases to exist as a legal entity. In the merger procedure, the surviving company issues new shares, which are allotted to the shareholders of the disappearing company in accordance with the merger ratio agreed to by both companies. As a result of this procedure, the shareholders of the disappearing company become shareholders of the surviving company.

Once the merger is effected, all of the rights and obligations of the disappearing company are transferred to the surviving company by operation of law. This means that all the assets, debts, rights, obligations, and agreements of the disappearing company would be automatically transferred to the surviving company without any particular act of either of the companies for the transfer. From an economic perspective, the surviving company's shares issued to the shareholders of the disappearing company could be considered as the consideration for acquiring all the business of the disappearing company.

However, any shareholder of either the surviving company or the disappearing company who has notified the company in writing, before the general shareholders' meeting to approve a merger agreement, of their intention to oppose the merger agreement at the general shareholders' meeting, and who in fact voted against the merger proposal at the meeting, may demand that the company purchase their shares at the fair value the shares would have had but for the resolution to conduct the merger (the appraisal right). This appraisal right ensures that minority shareholders who are opposed to the merger have an opportunity to redeem their invested capital.

Going private

A strong demand exists for transactions that would enable the acquiring company to obtain all of the outstanding shares of a Japanese public company (the target company), exclude minority shareholders of the target company, and to privatize the target company (the going-private transaction). The main reasons for this transaction are to achieve:

• flexible and efficient corporate management of the target company by eliminating the risk of lawsuits brought by minority shareholders and the costs associated with adjustment of interest between the acquiring company and the minority shareholders;
• reduction of the administrative costs that the target company bears as a public company, including the costs for complying with disclosure requirements under the Securities and Exchange Law (the SEL) or the stock exchange rules, and for the general shareholders' meeting; and,
• prevention of the outflow of corporate information through the disclosure as stated above or the general shareholders' meeting.

The Commercial Code, however, does not permit cash-out mergers except in the case of a merger implemented in accordance with the Industrial Revitalization Law (Sangyo-Katsuryoku-Saisei-Tokubetsu-Sochi-Ho)(the IRL) as mentioned below. Under the Commercial Code, a Japanese acquiring company is still able to make a Japanese public company its wholly owned subsidiary by using a stock-for-stock exchange. However, this method would not result in the acquiring company being able to benefit from all of the merits of going private, especially if the Japanese acquiring company would like to use its wholly owned subsidiary as a buyout vehicle. Moreover, under the Commercial Code, a foreign acquiring company is not able to use a stock-for-stock exchange to make a Japanese company its wholly owned subsidiary.

To achieve all of the merits of privatization, the following methods or similar methods have been practically used to squeeze out minority shareholders:

1. a buyout vehicle, a wholly owned subsidiary of the acquiring company, launches a tender offer on the target company (Target);
2. Target, based on a special resolution of a general shareholders' meeting, establishes a 100% parent company (Newco) by way of a stock-transfer (kabushiki-iten). The minority shareholders of Target who did not respond to the tender offer described in (i) above become the shareholders of Newco;
3. Newco sells its shares in Target (that is, all of the outstanding shares in Target) to the buyout vehicle; and,
4. Newco is dissolved based on a special resolution of a general shareholders' meeting and goes into liquidation, and Newco delivers cash to the shareholders of Newco (including ex-minority shareholders of Target) as the distribution of the residual assets.

In this regard, although each step of the above procedures is permitted under the Commercial Code, as a consequence of these procedures, minority shareholders would be squeezed out and deprived of the benefit of remaining as shareholders of Target, or the opportunity to take part in the business profits that the assets of Target would generate in the future. So an argument exists that, if these procedures are solely intended to exclude minority shareholders and have no proper business purpose, the resolution of a general shareholders' meeting regarding these procedures might be considered abuse of shareholders' rights because it unfairly harms the interest of the minority shareholders. A court might void such a resolution upon another shareholder's claim if it deems the resolution to be significantly unfair.

Accordingly, when carrying out the going-private transaction, it is practically necessary to pay considerable attention to the benefit of the minority shareholders.

For example, it is crucial that the minority shareholders be paid fair consideration to compensate them for their losing the opportunity to take part in the business profits generated from Target business in the future. Practically, the purchase price of the tendered shares with respect to the tender offer described in (i) above would include a considerable premium.

It is also important to provide adequate information to the minority shareholders under the tender offer procedure and other relevant procedures, to enable them to evaluate whether or not the consideration provided was fair. Also, to avoid unexpected damage to the minority shareholders, information regarding the procedure described in (i) to (iv) above should be disclosed in advance to the minority shareholders under the tender offer procedure and other relevant procedures.

Moreover, as a matter of practice, when implementing the going-private transaction, the acquiring company first launches a tender offer. This is because the fact that the larger portion of the minority shareholders of Target has spontaneously responded to the tender offer would be considered to support the fairness of the consideration paid to the minority shareholders. It is said that, in reference to the legislation of certain foreign jurisdictions that explicitly permits the squeeze-out of minority shareholders, and taking into account other considerations, the practitioners tend to view, as a matter of practice, this type of transaction as legal if the buyout vehicle could have obtained 90% or a similar amount of the outstanding shares of Target through the tender offer. So, as a matter of practice, the acquiring company tries to obtain 90% of the outstanding shares of Target through tender offer. In addition, in order not to be disparaged as a coercive two-tier takeover attempt, it is desirable for the cash provided to the minority shareholders as the distribution of the residual assets described in (iv) above to be about the same amount as the purchase price of the tendered shares with respect to the tender offer described in (i) above.

Going private

Industrial Revitalization Law

Although the cash-out merger is not, in principle, permitted under the Commercial Code as described above, there is one exception: a cash-out merger is available if, in accordance with the IRL, a competent minister has approved of the provision of cash to the shareholders of the disappearing company as necessary and proper to implement an approved plan that belongs to one of the following categories:

• (self-) restructuring plan: a plan to concentrate management resources on its own core business;
• business transfer and restart plan: a plan to acquire a business of another company and to make effective use of it; or
• co-restructuring plan: a plan to concentrate a number of companies' businesses that have an excessive supply problem, and to dispose of excessive production capacity or to invest large amounts into a technology-intensive cutting-edge field.

Much the same is true with respect to the use of shares of other companies (including a foreign company) as merger consideration. In addition, the IRL permits this exception not only in the case of merger but also in the case of stock-for-stock exchange and absorption-type demerger (kyusyu-bunkatsu). In the case of a going-private transaction, the business transfer and restart plan has been often used when the acquiring company is a private equity fund.

Accordingly, if a cash-out merger based on the approval of the competent minister in accordance with the IRL is available, it is possible to achieve privatization by using it (where the buyout vehicle would be the surviving company and Target would be the disappearing company) instead of the stock-transfer described in (ii) above. Even in this case, however, it is practically usual for the acquiring company to first make a tender offer. Because a competent minister has approved the cash-out merger as necessary and proper as described above, it is generally understood, as a matter of practice, that the proper business purpose and the fairness of the consideration of the going-private transaction would be supported by the fact of the approval itself.

However, a cash-out merger is not a tax-free transaction under the Corporation Tax Law of Japan (Hojinzei-Ho) as described below. Moreover, the succession of the licences and approvals that Target has obtained for its business, to the buyout vehicle might be difficult. Therefore, to avoid these disadvantages, a cash-out stock-for-stock exchange based on the approval of the competent minister in accordance with the IRL can be used instead of cash-out merger. That is, the buyout vehicle would be the 100% parent company of Target and the buyout vehicle would deliver cash to the minority shareholders of Target as consideration for the stock-for-stock exchange.

More flexibility to M&A consideration

As described above, under the Corporate Law, the surviving company would be able to use various kinds of its assets as merger consideration. Although the Corporate Law does not explicitly limit the scope of such assets available as merger consideration, a cash-out merger and a forward triangular merger are expected to be practically used under the Corporate Law. Much the same is true with regard to a stock-for-stock exchange and an absorption-type demerger.

Possible use of cash-out merger by foreign company

Although a foreign company cannot effect the stock-for-stock exchange with a Japanese company to make the Japanese company its wholly owned subsidiary under the Commercial Code or Corporate Law, it could use the cash-out merger to squeeze out the minority shareholders of Target and make Target its wholly owned subsidiary under the Corporate Law. First, a foreign company establishes a wholly owned subsidiary as buyout vehicle in Japan. Second, the buyout vehicle effects a cash-out merger with a Japanese company (that is, Target). As a result, the buyout vehicle acquires all of the outstanding shares of Target and the minority shareholders in Target are squeezed out. This would enable the foreign company to enjoy benefits such as saving the costs for adjustment of interest between the foreign company and the minority shareholders in Target.

The Corporate Law has different requirements regarding the resolution of the general shareholders' meeting of the disappearing company, which vary depending on the type of merger consideration. Details will be determined by a ministerial ordinance, which has not been publicized yet. But at least where Japanese yen is used as merger consideration, a special resolution of the shareholders' meeting (which requires an affirmative vote of two-thirds or more of the voting rights present at the shareholders' meeting, provided that there is a quorum of more than one-half of all the voting rights of the company) is expected to be required, as is the case with a merger under the Commercial Code.

Going private under the Corporate Law

A tender offer practically constitutes the first step of the going-private procedures as described above. This practice, however, might change under the Corporate Law. The Corporate Law explicitly provides for a cash-out merger procedure. Also, with respect to adequacy of information to the minority shareholders, more detailed information regarding the merger consideration, such as a written explanation of the merger consideration prepared by relevant parties, would be required to be provided to the shareholders under these merger procedures than under the Commercial Code. Moreover, the appraisal right would be friendlier to the squeezed-out shareholders, as set out below. For these reasons, under the Corporate Law, the necessity of the tender offer from the viewpoint of protection of minority shareholders interests might be diminished. Although further practical consideration and discussions among scholars and other authorities are needed, examples of the going-private transaction without a tender offer might emerge under the Corporate Law regime.

Appraisal right

In a cash-out merger, the synergy arising from the merger would not be distributed to the squeezed-out shareholders of the disappearing company if the amount of the cash distribution is calculated based on the value of Target before the merger. In this regard, under the Corporate Law, the share purchase price based on the appraisal right of the opposing shareholder could include such synergy, because the language of the relevant provision has changed from "the fair value the shares would have had but for the resolution to conduct the merger" under the Commercial Code to "the fair value" under the Corporate Law. As the court would determine the purchase price unless agreed between the company and the shareholder, there is much interest in court practice in this regard. From a practical perspective, merging companies would need to determine the proper merger ratio of the cash-out merger considering such synergy. This is the case with respect to any type of merger other than a cash-out merger.

Tax treatment of cash-out mergers

A tax-free merger under the Corporate Tax Law is a merger where assets other than the shares of the surviving company are not delivered to the shareholders of the disappearing company and that falls under an "intra-corporate group merger" or a "merger for conducting joint business" (and meets certain requirements).

Accordingly, as long as the current tax treatment is not changed, a merger whereby the assets other than the shares of the surviving company are delivered to the shareholders of the disappearing company, including a cash-out merger and a forward triangular merger in accordance with the IRL or the Corporate Law, would not be categorized as a tax-free merger, and the capital gain with respect to the assets transferred from the disappearing company to the surviving company would be taxed.

In this regard, to facilitate the use of the amendment that provides flexibility vis-à-vis the consideration of an M&A transaction, it is critical to expand the scope of the tax-free transaction. In this respect, trends of amendments to the Japanese tax law – that is, what type of consideration (cash, the shares of the acquiring company's 100% parent, or other assets) would be permitted to enjoy a tax-free treatment – are significant and ought to be monitored.

Author biographies

Takefumi Sato Nishimura & Partners Takefumi Sato first joined Nishimura & Partners in 1995, and now specializes in a number of areas of law related to corporate activity. In particular, mergers and acquisitions, corporate restructuring, business alliances, joint ventures, and general corporate law make up the bulk of his practice. Sato is a graduate of the University of Tokyo (LLB, 1993), the Legal Training and Research Institute of the Supreme Court of Japan, and Columbia University School of Law (LLM, 2002). He qualified in Japan in 1995 and in New York in 2003. Fluent in both Japanese and English, he has contributed to a number of Japanese and international journals and publications, including as co-author of Corpus Juris M&A (Shoji Homu, 2001). Daisuke Matsubara Nishimura & Partners Daisuke Matsubara is an associate at Nishimura & Partners. His main areas of practice are M&A transactions, group restructurings, joint ventures and general corporate matters. He is a graduate of Kyoto University (LLB, 2000) and was admitted to the Bar in Japan in 2001.