Corporate defence mechanisms

Author: | Published: 5 Jan 2004
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Contested bids among Japanese firms in the post-war period have been rare. The no-hostile-takeover social norm in Japan has denigrated such takeovers as unethical, and therefore operating as low-cost substitutes for an extensive system of legal rules for such activity.

Procedural safeguards in tender offers as well as securities anti-fraud rules remained underdeveloped through the 1980s. For instance, until 1990, there were no disclosure requirements under the securities laws. This made it possible for a corporate raider to secretly amass shares of a public company and thrust itself upon unsuspecting management.

As well as cultural beliefs and the lack of adequate legal frameworks still making hostile takeover bids less likely, there are various business and structural impediments. One of the most effective is the established practice of stable cross-shareholding among Japanese banks and corporations. In assessing how to answer to a tender offer, the strategic shareholders would generally consider not only the attractiveness of the share premium offered, but also, and perhaps most importantly, the profitability of existing business relations with the target and the likelihood that the takeover will succeed.

However, the past few years have witnessed unprecedented - at least by Japanese standards - hostile M&A activities. The emergence of a stronger corporate control market in which firms with poor financial performance cannot maintain their cross-shareholdings is becoming a reality. When considering recent deals as Cable & Wireless's acquisition of IDC and Boehringer Ingelheim's acquisition of a blocking stake in SS Pharmaceuticals, Japanese management no longer seems immune from hostile acquisitions or other unwelcome shareholder advances. And investment banks are no longer discouraging foreign clients from hostile bids.

Tender offers and stock accumulation

In 1991, Japan instituted a mandatory bid rule requiring that any offer to buy more than 33.3% of a target's shares should be made through a tender offer to all shareholders. In principle, tender offer rules apply whenever shares are acquired outside of the securities markets, with a few exceptions. This broad rule is designed to protect minority shareholders by ensuring they receive a pro rata share of any control premium, and by ensuring disclosure of even a private purchase where a majority shareholder would emerge.

It should be noted that, because of strong requests by industry sectors, the Financial Services Agency (FSA) is now discussing to amend the one-third share capital Takeover Bid (TOB) requirement. In November 2003, the Financial System Counsel (Kinyu-shingi-kai) began a study into this and while nothing has been determined by press time, discussions have proposed the requirement be changed to a half. The FSA expects to submit its bill on this to the Ordinary Diet Session of 2004 with the legislation effective by the end of 2004.

The Securities and Exchange Law (SEL) states that when a person buys stock in a registered company either outside the securities market or over-the-counter, the person shall make a tender offer (kokai kaitsuke) to the general public by using the TOB system, except when:

  • the total amount of stock bought by a buyer and its affiliated persons is less than 5%;
  • the stock the buyer owns after the transaction is less than one-third of share capital, provided that stocks are bought from 10 or less persons and/or less than within a 60-day period; and
  • an acquirer, using stock purchase rights of claim, issues common stock pre-emptive rights for convertible bond conversion privileges (which also apply to share acquisition rights (SARs or shinkabu-yoyakukeu)).

Takeover Bid procedures
Firstly, a brokerage house or financial institution must be selected as the agent to file paperwork and ensure payments of fees.

Secondly, a TOB acquirer must submit a public notice of the offer in at least two daily newspapers to announce the purpose of the buyout, the price, the number of stocks it plans to buy, duration and tender offer terms and conditions, and contracts to be disclosed regarding shares, voting rights agreements, or collateral agreements. The acquirer must also submit the tender offer registration statement or TOB application (statement and basic financial information about the acquiring company) to the relevant local finance bureau on the same day. The acquirer must also send a copy of the application to the target company, stock exchange authorities and the Japan Securities Dealers Association.

Thirdly, the duration of the offer must be between 20 and 60 days. In the case of competitive bidding in the TOB, the offer period can be extended.

Fourthly, detailed terms of the offer must be sent to all shareholders of the target company who expressed an interest in selling their shares to the bidder. Purchase price and other conditions for the TOB shall be made equally to all shareholders.

Fifthly, the TOB conditions may be changed during the tender offer period, except in relation to: reducing the purchase price; decreasing the number of stocks to be acquired; and changing the buyout terms. Withdrawal of a TOB, however, is not permitted unless a material event, such as bankruptcy, occurs.

Finally, there are no fair price rules, but if a tender offer is required, the price must be no less than the highest price paid outside the market in the last 60 days.

A tender offer under Japanese law does not necessarily achieve full control. There are no so-called squeeze-out provisions, which would force minority shareholders to sell their shares to a successful TOB acquirer, and minority shareholders cannot be squeezed out for cash.

No mandatory offer
There is no statutory requirement for mandatory offers, nor any level at which a mandatory general offer on all the shares of a company is required. However, if a buyer wants to acquire at one time a holding from a specified group of sellers, and this triggers a tender offer requirement, then it may be necessary to acquire the whole company because the accepting shareholders would be entitled to participate in the offer on a pro rata basis.

In practice, however, techniques are used to avoid a tender offer for all outstanding shares. The bidder would launch a tender offer specifying a minimum number of shares it wants to buy (but no maximum). This amount generally corresponds with one that is pre-negotiated with one or several core shareholders of the target, resulting in the bidder accepting the tender of all shares by the core shareholders during the tender offer period. Further, the bidder and core shareholders seeking liquidity (cashing out large blocks of shares) would often agree on pre-arranged offers at prices below prevailing market prices to ensure other shareholders have no incentive to tender their shares. About half of all tender offers in Japan are transacted on offer price below the market price.

Duties of directors taking defensive measures

Directors' duties during contests for corporate control remain unclear and untested in Japan. Few statutory laws and little case law relate to directors' duties and the responsibilities of Japanese companies in the context of contested or competitive bids. The question of the adequacy of the measures and actions taken by the corporate management would likely be determined by the Japanese courts by applying the traditional rules under the Commercial Code, in particular, the duty of care and the duty of loyalty.

The duty of care and the duty of loyalty
Under Japanese law, the directors owe duty of care (Article 254 of the Commercial Code, Article 644 of the Civil Code). The director's duty of loyalty (Article 254-3 of the Commercial Code) was added to the Commercial Code in 1950 as a direct import from the US. Article 254-3 of the Commercial Code provides: "Directors owe to the company the duty to perform their functions faithfully, in compliance with the laws, the company's charter provisions, and resolutions of shareholders meetings." It should be noted that the Japanese courts usually do not separately apply the duty of loyalty and the duty of care.

A Supreme Court decision of June 24 1970 adopted the view that Article 254-3 clarifies and restates the duty of care (similar to a duty of diligence of a good manager) but does not constitute a separate or higher duty for corporate directors. The development of the defence mechanisms and strategies will make the Japanese courts face more opportunities to give meaning to those abstract standards in the context of hostile takeovers.

Business judgment rule
In the US, the business judgment rule plays an important role in giving management certain autonomy. The rule provides that directors are not liable for judgments in which they did not have any personal interest, and which were made with knowledge that they reasonably believed to be sufficient in the circumstances and in the rational belief that the decision was compatible with the best interests of the company.

The doctrine of the business judgment rule is yet to be firmly established in Japan, although some lower court judgments have referred to it. The Tokyo District Court judgment of September 16 1993 applied a Japanese version of the business judgment rule to a case where the directors of Nomura Securities Co, Ltd were sued for paying illegal compensation to preferred customers. The Tokyo District Court found the directors not liable under the business judgment rule. It is still uncertain how the duty of care/loyalty and the business judgment rule would be applied to the management actions against hostile takeover.

Possible defensive mechanisms

In the event of an unsolicited, hostile takeover bid for the publicly listed shares of a Japanese company, the management can consider various defences in response. Although none would be certain to succeed, depending on circumstances the bidder might be deterred from continuing to pursue the offer.

Reactive versus preventive measures
If no reactive measures are in place, the timing required to carry out such measures against a takeover attempt, for example the convening of the company's general assembly to be held during the offer period, could make reactive measures of little use. It can leave the target company vulnerable and unable to effectively respond to an unsolicited bid.

Issuing new shares to a friendly unaffiliated third party (white knight) or an existing shareholder after a takeover has started may be considered illegal under the primary purpose doctrine described below. By contrast, preventive anti-takeover measures could be carried out before a potential threat and appear more effective to deter a business or financial raider.

Risks of issuing new shares
There are a few cases concerning the use of issuing shares to white knights as a defensive measure once a takeover has started. In a case decided by the Tokyo District Court in 1989, the court decided to void the target management's white knight stock placement as unfair where the primary purpose of the issuance was to dilute the holdings of the bidder and to maintain control over the company. The court confirmed that the issue price in question was determined without regard to market price and is deemed as a specially favourable issue price, as defined in Article 280-2(2) of the Commercial Code. The court's opinion was: that the primary purpose of the target company's issuance of new shares in question was to reduce the competitor's shareholding ratio and to maintain the existing directors' control over the company; that the issue of new shares was undertaken, at a minimum, with the knowledge that it would result in a marked drop in the competitor's shareholding ratio; and that the issuance of new shares of such a large amount was not justified, and, therefore, was grossly unfair.

The so-called primary purpose rule was also adopted in Takahashi Sangyo v Miyairi Valve (Tokyo District Court, September 5 1989). In that case, the court did not enjoin the issuance of the shares. The court held that the primary purpose was for external financing and that it could not conclude with the evidence that the primary purpose was for entrenching a competitor or the bidder. The courts' application of the primary purpose rule has been unpredictable, leading management to consider preventive measures against hostile takeover bids rather than reactive measures.

Preventive measures
A basic defensive measure would be for the company to agree in advance with one or more of its core shareholders to repurchase its (or their) shares in the company in the event of a threat of a hostile takeover bid. Before the 2001 Amendment to the Commercial Code, repurchasing treasury stocks was generally prohibited. However, after the amendment a company can repurchase its own shares as treasury stock.

To do this, a company would have to satisfy two requirements. Firstly, the shareholders must authorize the buy-back and certain basic terms and conditions, such as amount and price, at the annual general meeting (AGM), which is held in June for most Japanese companies. Secondly, the aggregate price the company would be allowed to pay for the buy-back must be limited to the surplus, that is, tier-two capital (shihon junbikin).

If approved by shareholders, and up to the maximum amount allowed given the company's available capital, a board of directors has a lot of discretion and flexibility in carrying out the repurchase programme in terms of number of shares, timing and price. Advantages of this defence are that once authorized by shareholders, it can be implemented quickly, eliminating the need to identify a white knight and provide certain deterrents for a potential bidder. A disadvantage is that even with a large amount of surplus and cash reserves, such a large buy-back of shares could have a rather negative impact on the company's financial condition. Another problem appears to be that if the company acquires shares constituting more than one-third of its share capital, it would generally trigger tender offer requirements under the SEL (for its own shares).

Considerations for a pre-emptive white knight strategy
The most obvious defensive reaction against a hostile bid for the company would be to agree in advance with a white knight to launch a counter bid or other transaction on the company's shares. This would enable the company's management, under the protection of the white knight, to maintain effective control on the business and indirectly deter a bidder because of the risks associated with indirectly acquiring only a minority shareholding in the company.

This strategy and the selection of a white knight must be considered carefully because it often results in an unwanted change in control rather than in achieving successful independence of the target. In practice, the white knight strategy often requires a group of unaffiliated white knights to circumvent the restrictions on the choice of white knight and to limit the risks of betrayal by diversifying the risks among several white knights. Although typically a white knight defence is used as a reactive measure rather than pre-arranged as a preventive measure, a company can explore with financial institutions and other strategic, non-competitive parties structuring a defence in advance. The risk is, of course, that the strategy becomes known in the market and the company's vulnerability is highlighted. A hostile bid may be the unwelcome result.

Restrictions on choice of white knight
Under Japanese law, there are certain limits to having a single white knight as a bank or an insurance company, although certain structures may circumvent those restrictions. For instance, Article 16.3 of the Japanese Banking Law provides that certain financial institutions (domestic and foreign banks) are prohibited from holding more than 5% of the outstanding shares of a Japanese company. Bank holding companies are not directly subject to this restriction because they are not banks as such. The Banking Law prohibits a bank holding company from holding (together with its subsidiaries) more than 15% of the voting stock of any Japanese company. The universe of entities that could act as a white knight to hold a certain portion of the shares in the target company is therefore limited. It might be possible to structure the white knight defence so that a group (at least two) of financial institutions acting as white knights is used, where, for example, two friendly bank holdings acquire 15% each of a core shareholder's shareholding in the target company. The above restrictions do not to apply to bank subsidiaries (to the extent such subsidiaries are not mere special purpose entities or conduits), securities companies, private equity funds, leveraged buyout funds, trust companies, or other financial institutions not covered under the Banking Law.

Transfer of core shareholdings to white knight(s)
The transfer or sale of a core shareholder's holding in the company to a white knight, or a group of white knights (whether or not an existing shareholder of the company), would generally trigger the requirement to launch a tender offer to all shareholders of the company if the white knight crosses the one-third threshold. One strategy could be for a core shareholder or a group of core shareholders of the target company to transfer its (or their) shares to a white knight or a group of white knights in an amount constituting less than one-third of the total outstanding. However, the tender offer rules may apply if a voting rights pooling arrangement is entered into between the new shareholders acting as white knights and/or with certain existing core shareholders according to the SEL's special relationship rules. These would result in all voting rights of the parties being in a special relationship under the voting agreement and therefore aggregated and exceeding the one-third threshold.

Validity and enforceability of poison pills
Shareholder rights plans, more commonly known as poison pills, have been an effective deterrent to hostile takeover bids in the US for nearly 20 years. The legality of poison pills has been upheld and the structures have evolved and become an accepted part of the preventive defensive strategy of many large publicly listed companies.

No major Japanese company seems to have adopted a poison pill and no Japanese court has ruled on its legality. From a legal perspective, one of the biggest problems in designing a poison pill within the Commercial Code relates to the unequal treatment of all shareholders. Under Japanese commercial law, it has been established that shareholders should be treated equally. As a board member of a Japanese company, a director should exercise reasonable care in reviewing any poison pill proposal before a hostile bid because once a bid is made, a director would be scrutinized as to whether he adhered to his fiduciary duties. Certain motives for creating a poison pill include: self-interest of management; negotiation tactics (management wants to use defensive tactics to increase the price offered or to find a better offer); and timing considerations (management believes that selling the company is not in the shareholders' interests).

For many years, the Commercial Code has not provided managers with the flexibility to craft US defensive mechanisms such as the poison pill. As noted below, however, with the example of share acquisition rights (SARs; shinkabu-yoyakuken), several amendments to the Commercial Code over the past 10 years can be viewed as increasing the flexibility of managerial discretion and enhancing corporate defence measures, despite the amendments not being intended as such. Japanese companies are now considering using those new tools as shark-repellent mechanisms, for instance the more flexible issuance of non-voting shares, restricted voting rights attached to any class of shares and special class of shares with certain veto powers.

Share acquisition rights as poison pills
Introduced on April 1 2002, SARs were first used by WalMart in its phased acquisition of Japanese retail chain Seiyu. The rights are similar to stock options that can be used as an acquisition tool. However, a number of legal commentators believe SARs may be used as poison pills by issuing them to a favourable business partner or existing shareholders.

SARs and common stock are different securities. The SAR-holder becomes a shareholder of the company on payment of the exercise price to the company. Therefore, until the option-holder pays the exercise price, it has no shareholder rights with respect to the shares to be issued or delivered. One limitation is that the value of the SARs must be limited to the amount of authorized capital (four times the amount of the paid-in capital).

The main merits of SARs are five-fold: (i) they generally require only a board of directors decision; (ii) they would not trigger a TOB requirement for the SAR-holder even if, on conversion, its shareholding in the issuing company exceeds the TOB thresholds; (iii) there is certain flexibility for the board of directors to structure the terms and conditions of exercise (for example, a hostile TOB on the company or on a company group's strategic partner, or more generally any unfavourable share purchase); (iv) there is no statutory limit in time to exercise the SAR; and (v) the exercise of the SARs by a white knight would have the effect of diluting all other existing shareholders, including certain core shareholders' shareholdings in the company, providing an effective deterrent to a potential raider.

SARs may technically operate as poison pills, as in Europe and the US. Yet it is unclear whether Japanese courts would consider this issuance illegal or inappropriate under the Commercial Code, particularly in the case where the SARs are issued to one friendly business partner or white knight.

The use of SARs as poison pills has never been tested in court and it is not believed that any implementation in practice of SARs schemes as poison pills has occurred yet in Japan, although several Japanese companies are studying the feasibility. Certain commentators are pessimistic about the validity but it is difficult to predict at this stage whether Japanese courts would consider the issuance illegal or inappropriate under the Commercial Code (particularly based on breach of fiduciary duties by directors and principles of equality between shareholders).

Despite the uncertainties, certain variations of SARs structures might work in Japan.

White-knight defence structure
Issuing SARs to all shareholders using SPC/trust bank and employees' shareholding fund as an additional white knight

White knight structure using SARs issued to all shareholders

The originality of the diagram is that SARs are issued to all the company's shareholders, therefore limiting the risks of violating shareholder equality. There is no protection under the Commercial Code for shareholders such as standstill that would guarantee them to maintain their initial shareholding percentages in the company. Further, to limit the risks that the issuance is being considered unfair or unreasonable, the SARs need to be made redeemable by the board of directors in case of best offer, therefore enabling the hostile acquirer to present its best offer and thereby avoiding the dilution effects.

The diagram illustrates a combination of a structure that has been discussed by practitioners in Japan - using the special purpose company (SPC) and trust arrangement as an intermediary conduit to which SARs are granted, and the sale of a core shareholder's shareholding in the company to a white knight. The exercise of SARs by all shareholders and the white knight(s) in case of an unsolicited bid would have the effect of diluting core shareholders' holdings in the company. The purpose of the SPC/trust structure is to reduce the problems of valuation mismatch between the SARs and the stocks of existing shareholders, by stapling the SARs and the underlying stocks together and instructing the trust administrator to exercise, on behalf of all the company's shareholders, the SARs upon certain trigger events.

The structure is also aimed at reducing the risk that a white knight enters into a private agreement with the hostile acquirer, by dividing the risks between several white knights and to use employee shareholders' funds or associations of the target company generally considered as loyal white knights.

Using an employees' shareholding association of a company or a subsidiary to acquire all or a large amount of a core shareholder's shares in the company to reduce or eliminate a core shareholder's control, might be a potentially creative and sound approach to transfer one's shares to a third party. It may be possible to contractually structure the company's employee shareholders in a fund often referred to as mochikabukai. If financing is necessary (that is, employee contributions are not enough, though the exercise price of the SARs should be low), the Jugyouin Mochikabukai may be structured as a leveraged fund whereby the mochikabukai would take a loan from a third party bank or enter into a total return equity swap agreement.

Author biographies

Etsuo Doi

Orrick Tokyo Law Office

Etsuo Doi is a partner with Orrick Tokyo Law Office, Orrick Herrington & Sutcliffe, a registered associated law office in Tokyo. He and is a member of Orrick's corporate department. His practice is broad, including experience in representing both Japanese and international companies in cross-border transactions, including intellectual property and e-commerce related matters, cross-border M&A, joint ventures, licensing and general corporate work.

His recent M&A and joint venture experience includes strategic alliances involving a world-leading internet company, joint venture arrangements involving one of Japan's leading cosmetic companies and joint venture arrangements involving setting up a leading museum's new Tokyo branch.

Before joining Orrick, Doi was corporate counsel at eBay Inc, engaged in various corporate matters including strategic expansion of eBay's business abroad.

He is admitted to practice in Japan and New York.


Laurent Develle

Orrick Herrington & Sutcliffe

Laurent Develle is a partner of Orrick Herrington & Sutcliffe in Tokyo. He has worked in Japan since 1994. His practice mainly focuses on strategic alliances, joint ventures, M&A, hostile takeovers and private equity investments in Japan. His clients include European, US and Japanese multinationals and several financial institutions. He has expertise in assisting clients in the life sciences, financial services and automotive industries.

His recent M&A experience in Japan include: advising a European leader in urban planning on its strategic alliance and joint venture with a large Japanese trading company; helping a large Japanese company with structuring anti-takeover defence mechanisms in an existing complex cross-border strategic alliance; advising a big US automotive component maker on the disposal of a strategic shareholding in a Japanese listed company; and helping a large European luxury and fashion group acquire a Japanese joint venture partner.

Develle is a graduate of the Paris Institute of Political Studies and was awarded the First National Prize in Economics in France. He is admitted to practice law in France and in Japan as a Gaikokuho-Jimu Bengoshi (foreign lawyer). He is fluent in French and English, and conversant in Japanese.



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