Regulatory obstacles to acquisition

Author: | Published: 1 Dec 2008
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With the increasing globalisation of world business, the number of cross-border M&A deals and the total value of such deals have both been on the rise. In cross-border M&A transactions, it is important to identify at an early stage any regulatory obstacles, especially those imposed in the jurisdiction of the target company or on the target business, which may affect the structure or schedule of the contemplated transaction or frustrate it in any other way. The main regulatory obstacles in such transactions include the securities and antitrust regulations of the relevant jurisdictions. However, careful attention should also be paid to the inward foreign investment regulations.

Although the liberalisation of inward foreign investments is one of the principles of international investment rules, most countries impose inward foreign investment regulations. The global environment surrounding inward foreign investments has changed in recent years. There have been, for example: (i) increasing threat to national security due to the proliferation of weapons of mass destruction and international terrorist networks; and (ii) the expansion of cross-border M&A transactions led by new market participants such as equity funds, sovereign wealth funds and companies from emerging economies. As a result, many of the main countries for M&A transactions (including the US, the UK, Germany and France) have amended and tightened their inward foreign investment regulations.

Due to this change in the global environment surrounding inward foreign investments, Japan has also experienced remarkable developments in inward foreign investment regulations in recent years. Though the Japanese government is continuing with its efforts to promote foreign investment into Japan, the inward foreign investment regulations under the Foreign Exchange and Foreign Trade Control Act (FEFTCA) were amended in September 2007. The amendments included an expansion of the categories of restricted industries under the FEFTCA for the first time in 16 years. In May 2008, the Japanese government issued the first discontinuance order under the FEFTCA against an acquisition of the shares of an electric power company in Japan by a foreign investment fund.

Regulatory framework

The Organisation for Economic Co-operation and Development (OECD) Code of Liberalisation of Capital Movements, an international investment rule on the liberalisation of inward foreign investments, allows OECD members to take measures necessary to: (i) maintain public order or protect public health, morals and safety; (ii) protect their essential security interests; and (iii) fulfil their obligations relating to international peace and security. In general, Japan's regulatory framework for inward foreign investments is based on such measures. The approach of the Japanese legal framework towards inward foreign investment regulations is two-fold.

One approach is to require foreign investors who intend to acquire more than a certain percentage of shares in a Japanese company that engages in a restricted business (as specified by the regulations) to file an advance notification and to subject such proposed investment to review by the relevant government authorities. This approach has been adopted in the cross-industry inward foreign investment regulations under the FEFTCA, which corresponds to the Exon-Florio Amendment, a well-known inward foreign investment regulation in the US. However, regulations under the Exon-Florio Amendment do not specify the industries subject to review but covers all industries from the perspective of national security. Furthermore, regulations under the Exon-Florio Amendment do not impose any obligations to file an advance notification, but any investment may be subject to investigation for a certain period of time after the completion of such investments (however, the relevant parties to an investment that may be a cause for concern under the Exon-Florio Amendment may voluntarily file an advance notification with the US Committee on Foreign Investment). On the other hand, the FEFTCA specifies the restricted businesses that are subject to the requirement of an advance notification.

The other approach is to establish an upper threshold of the ratio of voting rights that may be held by foreign investors in Japanese companies in certain industry sectors. Such regulations are generally found in industry or business-specific laws such as the Radio Act, the Broadcast Act, the Aviation Act and the Nippon Telegraph and Telephone Corporation Act. Though the FEFTCA controls the ratio of the voting rights that may be held by a foreign investor, these industry or business-specific laws control the aggregate ratio of the voting rights of the issuing company that may be held by foreign investors.

Regulations under the FEFTCA

The FEFTCA defines the inward foreign direct investments that are subject to filing requirements under it. The main types are: (i) acquisitions of 10% or more of the shares in a listed company (the shareholding ratio is calculated by including the number of shares held by the acquirer's officers, certain affiliates and officers thereof); (ii) acquisitions of shares in an unlisted company; and (iii) loans for more than one year made by foreign investors other than financial institutions exceeding ¥100 million ($1.1 million) and 50% of the outstanding debt of the target company.

Inward foreign direct investment in a Japanese company requires an ex post facto report. However, investment in a company that engages in a restricted business requires an advance notification to the Finance Minister and the minister responsible for the relevant industry and is subject to a 30-day waiting period (which may be extended by up to five months). In cases of concern (for example, where the inward foreign direct investment is likely to adversely affect issues such as national security), the authorities may recommend modifications to or even abandonment of the transaction and may subsequently order the same if the investor does not accept the recommendations.

Restricted businesses are those that are in: (i) industries that relate to national security (weapons, aircraft, space development or nuclear energy and manufacturing industries of certain particularly sensitive goods among goods regulated to be exported); (ii) industries that relate to public order (electric power, gas, heat supply, telecommunications, broadcasting, water services, railways and passenger transportation, among others); (iii) industries that relate to public safety (vaccination products and security services, among others); and (iv) industries restricted for reasons peculiar to Japan (agriculture, forestry and fishing, oil, leather and leather goods manufacturing, and air and marine transport, among others).

According to the Trade White Paper 2008 released by the Ministry of Economy, Trade and Industry, there were approximately 760 advance notifications over the past three years, all save one of the notified investments were approved within a 30-day waiting period and in 95% of the cases the waiting period was shortened to two weeks.

First discontinuance order issued

The first and only example of a recommendation and order to discontinue a transaction under the FEFTCA concerned the proposed acquisition of shares in Electric Power Development Co, Ltd (J-Power), an electric power company listed on the first section of the Tokyo Stock Exchange (TSE), by The Children's Investment Master Fund (TCI), a UK-based investment fund. TCI, which held 9.9% of shares in J-Power, submitted advance notification on January 15 2008 to the effect that it intended to acquire additional shares in J-Power to increase its shareholding to 20%. However, the Japanese government issued a discontinuance recommendation on April 16 2008 and a discontinuance order on May 13 2008 and, as a result, TCI gave up on the proposed acquisition of additional shares in J-Power.

When analysing this case, an understanding of J-Power's business is important. J-Power, which engages in the wholesale supply of electricity and in electricity transmission and transformation services, is expected to be the key participant in the nuclear fuel cycle in Japan. J-Power was originally incorporated by the Japanese government as a special public utility expected to ensure a stable supply of electricity, and was later privatised and listed on the TSE-1. When the government decided to issue the discontinuance order, it took into account that: (i) TCI had requested that J-Power commit to achieving minimum return on equity and return on assets targets and requested that J-Power's management be accountable for meeting those targets; and (ii) it was possible that, in order to meet TCI's requests, J-Power's planning, operation and maintenance of its backbone facilities, such as the Ohma nuclear plant, a cornerstone of the Japanese nuclear fuel cycle, would be influenced and a stable supply of electricity and/or Japan's nuclear fuel cycle could be affected.

Amendment to the FEFTCA

Due to changes in the global environment surrounding inward foreign investments, the inward foreign investment regulations under the FEFTCA were amended in September 2007. The main changes included the addition of manufacturing industries of certain particularly sensitive goods among goods regulated to be exported to the restricted industries specified in the regulations that require an advance notification, to address concerns that certain sensitive technologies that may be used for military purposes may flow out to other countries.

Furthermore, before the 2007 amendment it was unclear whether an advance notification would be required under the FEFTCA for an acquisition of shares in a Japanese company that does not engage in a restricted business itself but whose subsidiary is engaged in a restricted business. The 2007 amendment made it clear that an advance notification is required if any of the consolidated subsidiaries of the target company are engaged in a restricted business. Therefore, with respect to an inward foreign direct investment, it is necessary to review not only the business conducted by the target company itself but also the business conducted by any of its consolidated subsidiaries.

Industry and business-specific laws

Inward foreign investments in industries that have a greater importance to the general public are regulated by relevant industry and business-specific laws. The main ones that impose inward foreign investment regulations are: (i) the Radio Act and the Broadcast Act regulating broadcasters; (ii) the Radio Act regulating radio station operators (not limited to radio broadcast stations); (iii) the Aviation Act regulating air carriers and holding companies thereof; (iv) the Nippon Telegraph and Telephone Corporation Act regulating Nippon Telegraph and Telephone Corporation (NTT); and (v) the Freight Use Transportation Business Act regulating freight forwarders who arrange the carriage of goods using a carrier's transportation without having their own means of transportation.

These laws regulate the aggregate ratio of the voting rights of the issuing company that may be held by foreign investors. The maximum ratio for a broadcaster is 20%, while the maximum ratio for a radio station operator, an air carrier and/or a holding company thereof, NTT or certain freight forwarders is 33.33%. Indirect investments in broadcasters and NTT through Japanese entities are also regulated as inward foreign investments. If foreign investors acquire voting shares exceeding such maximum ratios, NTT is prohibited from registering such transfer of shares in its shareholder registry, and listed broadcasters, air carriers and/or holding companies thereof may refuse requests for the registration of share transfers in their shareholder registries. Also, where the ratio of voting rights held by foreign investors in a broadcaster exceeds the maximum by reason of an increase in the investment in a Japanese entity holding the broadcaster's shares, the shares representing the portion above the maximum ratio do not have voting rights.

In addition to the regulations on investment, officers of foreign nationality cannot be representatives of a radio station operator, broadcaster, air carrier, its holding company or a freight forwarder, nor can more than a third of the total number of officers of such companies be comprised of officers of foreign nationality.

Violation of the regulations on inward foreign investment or foreign officers in these companies may cause revocation or termination of certain licences, permissions or registrations that are necessary for the target companies to conduct business.

Although the purpose of the regulations is different from that of the inward foreign investment regulations, attention should also be paid to general capital regulations that may be found in industry and business-specific laws, including: (i) restrictions on voting rights that may be held by a single shareholder (broadcasters, financial instruments exchanges including securities exchanges, banks and insurance companies); (ii) holdings of a certain number of shares by the Japanese government (NTT, Japan Tobacco, Inc and Japan Post Service Co, Ltd, among others); and (iii) holdings of golden shares by the Japanese government, which is granted a veto right on certain important matters (INPEX Corporation, a company exploring and developing oil and natural gas resources).

Recent issues

In addition to the amendment to the FEFTCA, amendments to the Radio Act and the Broadcast Act making indirect investments in broadcasters through Japanese entities subject to the inward foreign investment regulations came into effect in April 2006. These amendments were made because Livedoor Co, Ltd (Livedoor), then a fast-growing internet service provider company, had acquired up to 35% of the shares of Nippon Broadcasting System, Inc, then a TSE-2 listed radio broadcasting company, with Livedoor obtaining the funds necessary for the acquisition by issuing moving strike convertible bonds to Lehman Brothers Securities Co, which would have given Lehman Brothers the power to indirectly control Nippon Broadcasting System if it had converted the bonds into Livedoor shares.

In 2007, after an investment fund of Macquarie group, an Australian investment banking group, had acquired up to 19.89% of the shares in Japan Airport Terminal Co, Ltd, a TSE-1 listed company managing the terminal buildings of the Tokyo International Airport at Haneda, the Ministry of Land, Infrastructure, Transport and Tourism (MLIT) intended to submit a bill to the Diet seeking to introduce regulations on inward foreign investment in airport operator companies. However, there was strong opposition to the bill from the government because the bill, if passed, would establish an ex post facto law to defend a listed company, and such lawmaking might adversely affect inward foreign investments into Japan, so the MLIT finally decided not to proceed with submitting the bill. Regulations on airport infrastructure are being studied by MLIT at present and, according to recent media reports, it is likely that capital regulations on airport infrastructure companies will not discriminate between domestic investments and inward foreign investments.

Inward foreign investment regulations and the enforcement thereof are inevitably affected by the global environment surrounding such investments, the regulations in other countries, the global and domestic economies and other political factors. The global economic depression originating from the US subprime loan crisis may affect the direction of inward foreign investment regulations in Japan. Although the specific direction of Japanese regulations is not certain at this point in time, a careful review and analysis of inward foreign investment regulations is important to implementing an acquisition of or investment in a Japanese company from the perspective of structuring an M&A transaction.

Author biographies

Kei Okubo

Nagashima Ohno & Tsunematsu

Kei Okubo is a partner at Nagashima Ohno & Tsunematsu, one of the largest law firms in Japan. His practice focuses on M&A and other corporate restructuring transactions. He also advises many Japanese and non-Japanese clients on general corporate matters. Kei worked at Morrison & Foerster in San Francisco as a visiting international attorney from 2005 to 2006. He graduated with an LLM from Stanford Law School in 2005 and with an LLB from the University of Tokyo in 1998. He was admitted to the Japan Bar in 2000 and the New York Bar in 2006.

Kan Watanabe

Nagashima Ohno & Tsunematsu

Kan Watanabe is an associate of Nagashima Ohno & Tsunematsu. His main area of practice is M&A and other corporate transactions. Kan graduated with an LLB from the University of Tokyo in 1999 and was admitted to the Japan Bar in 2004.