Cash-out transactions

Author: | Published: 5 Jan 2004
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The Commercial Code of Japan has generally been interpreted as precluding cash-out mergers or other transactio ns that have the purpose of eliminating minority shareholders through the payment of cash (cash-out transactions).

However, various types of cash-out transactions have been structured since the Code was amended in 1999 to introduce a procedure for statutory share transfers and exchanges. Although these transactions have not yet been challenged in court, many scholars express doubts about their legality. To lessen the risk of legal challenge, practitioners are trying to structure cash-out transactions taking into account legal precedents in the US.

In April 2003, the government amended the Law on Special Measures for Industrial Revitalization (the Industrial Revitalization Law) to allow cash-out mergers and certain other cash-out transactions subject to government approval. Although the Law is a temporary special purpose law, the government announced in October 2003 a tentative plan for amendments to the Commercial Code that would include procedures for cash-out mergers, cash-out share exchanges and cash-out corporate separations.

But even if these amendments are adopted, cash-out transacti ons will still need careful structuring given that the Code has historically been interpreted to disfavour consolidation of control by majority shareholders.

 Share transfer, asset sale and liquidation method

Historical view against cash-out transactions

The Code has long been interpreted as prohibiting majority shareholders from eliminating minority shareholders by paying only cash. For example, in a statutory merger, the surviving company is required to issue shares to shareholders of the merged company. Cash is paid only for limited purposes such as adjustment of the merger ratio. Behind this interpretation seems to have been the view that a share is more than a pure financial asset and that a shareholder of a company has some right to maintain its interest in the company.

The 1999 amendment to the Commercial Code that introduced procedures for a statutory share exchange and a statutory share transfer made it permissible by a shareholder vote to force all shareholders of a company to become shareholders of the parent company by operation of law. Supporters of cash-out transactions viewed this change as a historical step, showing that the Code no longer guaranteed a shareholder of a company the right to maintain an ownership interest in the company. Some scholars continue to insist, however, that a principle of continuity of ownership remains because, even with the new procedures, shareholders still have the right to maintain at least an indirect interest after a statutory share transfer/exchange. Thus, it is still being debated whether the 1999 amendment fundamentally changed the historical principle against cash-out transactions.

 Fractional share method

Recent cash-out transactions in Japan

In spite of legal uncertainties, a number of companies have recently structured transactions to effect a cash-out of minority shareholders. Cash-out transactions conducted in Japan can be divided into three categories, all of which are typically preceded by a tender offer from the acquirer, partly to obtain a majority interest in the target and partly to decrease potential legal risks.

The most frequently used method in Japan is a combination of a statutory share transfer, sale of shares of a target company (T) and liquidation of the target. After an acquirer (P) buys a significant equity stake in T (usually more than 90%) through a tender offer, T engages in a statutory share transfer, which requires a supermajority vote of T's shareholders at a shareholders' meeting. As a result of the share transfer, all T's outstanding shares become shares of a newly created parent company of T (New Co) by operation of law. New Co then sells its shares in T to P (or its affiliates) for cash. Finally, New Co is liquidated and its only asset, the cash, is distributed to its shareholders including minority shareholders leaving P with 100% of the shares of T.

This method is usually believed to be relatively less risky than the fractional share method because: (i) each step in the transaction when viewed alone is straightforward and not particularly out of the ordinary; and (ii) this method uses a statutory share transfer, which by its nature forces shareholders to give up their shares in T. On the other hand, this structure takes time. It requires at least two shareholders' meetings of T and New Co to approve the share transfer and the share sale and liquidation processes, and P temporarily needs additional cash to purchase all shares of New Co in step three even though P has already paid for the shares acquired through the tender offer in step one. Also, both the purchase of T's shares through the tender offer (step one) and New Co's sale of shares of T to P (step three) are subject to capital gains tax.

The fractional share method takes advantage of Article 220I of the Commercial Code. This provides a method for cashing out certain fractional shares that are created in certain statutory transactions including share exchanges/transfers and mergers. For example, a subsidiary of P (S), which has purchased a significant portion of shares in T through a tender offer, merges with T at such an extreme merger ratio that no minority shareholder of T is entitled to anything but certain fractional shares of S. After the approval of this merger at the shareholders' meeting(s) of T (and S), T cashes out the fractional shares and distributes cash consideration proportionately to minority shareholders. This cash-out method can be completed more quickly than the share transfer, asset sale and liquidation method because only one merger procedure requiring shareholder approval is required. Also, it is arguable that capital gains tax on the assets of T could be deferred in certain circumstances because a cash distribution to shareholders because of the sale of fractional shares is usually not regarded as boot.

However, this process is generally interpreted as somewhat riskier than the first method because: (i) it intentionally uses such an extreme merger ratio to eliminate minority shareholders that has historically been regarded as a typical example of an abuse of rights by the majority shareholders; and (ii) the merger is substantially the same as a simple cash-out merger, which has generally been regarded as not being permissible under the Code. For these reasons, the structure is used less frequently than the share transfer, asset sale and liquidation method.

 Forward cash-out merger under the Industrial Revitalization Law

Using the Industrial Revitalization Law

A cash-out statutory merger (or share exchange) is permitted under the Industrial Revitalization Law as long as the relevant government bodies approve the acquirer, its business plan and the necessity and appropriateness to use cash-out transactions for achieving such a plan.

Typically, a tender offer is started at the same time as the approvals are obtained. After S acquires a significant portion of T's shares, S merges with T, and S, as the surviving company, distributes cash instead of shares of S to the other shareholders of T. This method needs time only for the tender offer and merger (similar to the fractional share method), so the required time period is shorter than the share transfer, asset sale and liquidation method. In addition, because the fairness of this plan, including the cash-out aspect, is approved by the government, it is less risky than either of the first two structures, meaning there is less possibility that the approved shareholder resolution will be rescinded because the court recognizes it as being significantly unreasonable.

But although it is likely the court will respect the government approval, or at least take it into account, it is still theoretically possible for a court to overturn the transaction. In addition, because the Industrial Revitalization Law does not provide preferential tax treatment for cash-out transactions of this kind, assets of merged T are subject to capital gains tax.

It should be noted that the cash-out merger permitted under the Industrial Revitalization Law is slightly different from a cash-out merger in the US. In Japanese version, the surviving company is able to distribute cash only to the shareholders of the merged company and not to the shareholders of the surviving company. In other words, only a forward cash-out merger is stipulated. But if a cash-out statutory share exchange and reverse merger are combined, it is possible to achieve the same result as the reverse cash-out merger.

This is particularly useful if T has a special licence that is not transferable to the surviving company through a merger. In addition, it would be arguable that the capital gains tax on assets of T should be deferred under certain circumstances, for example, if there is a legitimate business purpose for making T a surviving company. Therefore, this de facto reverse merger is likely to be used frequently in the future.

 De facto reverse cash-out merger under the Industrial Revitalization Law

Potential risks

Because a cash-out transaction eliminates minority shareholders without the necessity of obtaining their consent, there is a risk that minority shareholders will try to challenge the transaction in court. The main legal risk for cash-out transactions is the possibility that the resolution of shareholders that approved the transaction could be rescinded through legal action taken by a minority shareholder. This would invalidate the entire transaction. In addition, directors or statutory auditors of the target could be subject to a derivative lawsuit to recover damages to the company (Art 266I of the Commercial Code) or a direct lawsuit by shareholders for damages (Art 266-3 of the Commercial Code) caused by the directors' breach of duties of care as good managers (similar to fiduciary duties in the US). Furthermore, the acquirer or its affiliates could be held liable under general principles of negligence or willful misconduct under Article 709 of the Civil Code.

A resolution of shareholders can be rescinded if it is deemed as being significantly unreasonable because of the vote by shareholders having a special interest (Art 247 of the Commercial Code). In the cash-out transactions described above, the acquirer would usually be considered to have a special interest because it has purchased a significant amount of T shares and exercises its voting rights to those shares to adopt the resolution required to effect the cash-out transaction. Therefore, the issue is usually whether the resolution that approved the transactions was significantly unreasonable. The question usually boils down to whether the majority shareholders abused their rights.

No legal precedents provide useful guidance as to what constitutes an abuse of rights by majority shareholders. A scholar has posited that majority shareholders abuse their rights if they obtain unreasonable benefits (determined on the basis of a socially accepted standard) while the remaining shareholders are forced to bear disadvantages beyond the expectation of an average person participating in the company.

In the case of cash-out transactions, the benefits obtained by an acquirer are all shares of the target in exchange for cash. Whether these benefits are reasonable depends on the fairness of the cash consideration and, possibly, a more subjective standard of whether there was a legitimate business purpose, for example, cutting disclosure costs or improving management efficiency.

On the other hand, the disadvantages to be borne by the minority shareholders could be that they lose their interest in the target, the cash consideration may not be fair, and they do not have enough information to decide whether they should sell their shares, which should be determined according to an average person standard. Thus, in structuring cash-out transactions, it is prudent to ensure that the cash consideration is fair, enough information is disclosed to the minority shareholders and that the cash-out has a legitimate business purpose for its actions. Cash-out transactions are by their nature incompatible with any desire by minority shareholders to maintain an interest in the target company. However, practitioners believe that it is not unreasonable for the majority to override any such desire by the minority shareholders in certain circumstances.

Above all, the cash consideration distributed in cash-out transactions must be fair. In past cash-out transactions in Japan, at least a 20% to 30% premium has usually been added to the market price of shares of the target, which is often calculated according to the average of the market price over a certain period.

The problem is that a fair price is not easy to be found. Particularly, the acquirer will usually have more information about the target than the minority shareholders because of the due diligence process customary in a transaction of this kind. The acquirer can also control the timing of the transaction or certain other factors to create a relatively low market price to make the offered price more attractive. Therefore, it is necessary to take steps to ensure that the cash consideration is fair, including disclosures to cure the information asymmetry between the acquirer (or the management of the target) and the minority shareholders and the involvement of a neutral and objective party or expert in the transactions.

Disclosure is key to give existing shareholders a chance to evaluate the reasonableness of the transaction, including the fairness of the cash consideration. At a minimum, the acquirer should disclose information about itself, the value of the target, and the transaction structure, including the purpose, method of pricing and any second-step cash-out plan (including the cash-out price to remove the risk involved with coercive two-tier transactions). In this regard, starting with a tender offer is generally regarded as a good way to ensure that certain information stipulated in securities regulations is disclosed systematically.

In addition, cash-out transactions have generally been conducted with the prior approval of the board of directors of the target. The board of directors, which owes duty of care to the shareholders in general, has more information than the public investors and the acquirer. The fact that the board of directors negotiates with the acquirer and recommends the transaction to the shareholders should constitute a presumption that the transaction has been conducted on an arm's length basis and that, therefore, the cash consideration is fair. But if the directors have a conflict of interest in the transaction, this presumption would not exist. Outside directors or third party experts are expected to play an important role where inside directors have a conflict.

Obtaining a fairness opinion from a third party expert is useful because it objectively supports the fairness of the purchase price. A lower court decision has supported the usefulness of a fairness opinion in defeating an action to rescind a shareholder resolution as being an abuse of rights by the majority shareholders.

Another important factor is the level of approval of the transaction as a whole by shareholders, because this constitutes a presumption of whether the average shareholder found the transaction to be fair. In this regard, starting with a tender offer is useful because the shareholders who tender their shares through the tender offer process could usually be regarded as agreeing with the fairness of the transaction as a whole, including the cash-out aspect.

Cash-out transactions conducted so far in Japan have been preceded by a tender offer. These transactions usually result in more than 90% of outstanding shares being tendered. Some practitioners believe that this 90% threshold is an important criterion in evaluating whether the transaction should survive a challenge by minority shareholders on fairness grounds. It should be also noted that this argument is true only when shareholders are given an opportunity to judge the transaction without any coercive pressure from a threat of a second-step cash-out at a cheaper price than the tender offer price. Therefore, the tender offer price should not usually exceed the second-step cash-out price.

Legislative developments

The government is in the process of introducing procedures for straightforward statutory cash-out mergers and other cash-out transactions in Japan. With the proposed legislation, only additional disclosure about the share price may be required, in addition to certain procedures presently required for a statutory merger.

However, introduction of these new procedures will not guarantee that cash-out transactions will be legal in all circumstances. Minority shareholders will still be able to challenge the shareholder resolution that approves the transaction, meaning that factors described above will still need to be considered even after the proposed legislation is enacted. Yet there does appear to be growing acceptance in Japan that cash-out transactions should be permissible in at least some circumstances.

Breaking taboo

Despite legal uncertainties, carefully structured cash-out transactions have recently been conducted in Japan. The proposed amendment to the Commercial Code is expected to relax legal restrictions on cash-out transactions. Although cash-out transactions will have to be structured carefully even after the new legislation to avoid being challenged by minority shareholders on fairness grounds, it is interesting that the proposed amendment is about to break the traditional taboo in Japanese corporate law against cashing-out minority shareholders.

Historically, the elimination of minority shareholders has always been considered unfair under Japanese law. But longstanding economic stagnation is bringing a change to the concept of fairness in Japan. The balance between protecting minority shareholders and allowing greater corporate flexibility seems to be shifting closer to that in the US. While it is not yet clear how far the balance will shift, Japanese corporate law is at a turning point.

Author biography

Gaku Ishiwata

Mori Hamada & Matsumoto

Gaku Ishiwata is an attorney with Mori Hamada & Matsumoto. He was admitted to the bar in 1997 in Japan and in 2002 in New York. He was educated at the University of Tokyo (LLB, 1995) and the University of Chicago Law School (LLM, 2001), and worked at Davis Polk & Wardwell in New York from 2001 to 2002.

He is the author of: Hostile Takeover Defense - Poison Pill, 2003; Buyouts under the Amended Law on Special Measures for Industrial Revitalization, 2003; Securities Regulations on the Issuance of Stock Options, 2003; Shareholders Meeting in 2003 - Legal Reserves and Reduction of Capital, 2003; Formation of Buyout Funds, 2002; Sarbanes-Oxley Act of 2002, 2002; and Methods and Options for Mergers and Acquisitions, 1998. He is co-author of Standard Form Agreements, 1999. He is a member of the Daini-Tokyo Bar Association and New York State Bar Association. From 2002 to 2003 he was also a member of the Society for the Study of the Limited Liability Company, organized by Ministry of Economy Trade and Industry.

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