Japan is amending its law on foreign investment to better protect domestic companies and improve corporate governance. For foreign investors, the change in rules will mean more due diligence, but also a change in how they approach activism more generally.
IFLR’s latest primer looks at how Japan, following changes in similar rules in the US and EU, is changing its law to protect domestic enterprises from increasing foreign ownership.
What does the investment law cover?
Japan has passed a bill that will cut the threshold requiring foreign investors to notify regulators before their share purchases in sensitive companies from 10 to one percent. Changes will be made to the Foreign Exchange and Foreign Trade Act, and are expected to be effective from May 2020.
Sensitive companies are those related to weapons, nuclear energy, semiconductors and railroads.
Japanese businesses will be allocated to one of three categories to differentiate between those that will be subject to the one percent threshold, those that may be exempt, and those that are not subject to the requirement.
How will foreign investment be affected?
There will be increased regulatory requirements for equity investors operating at scale, explains Martin King, managing partner at Tyton Capital Advisors. For example, if a hedge fund wishes to take a short-term position in a small or micro-listed Japanese company, it will need to notify the Ministry of Finance when it breaches the one percent threshold. The investor's use of capital may change to avoid the added expense of the newly mandated reporting. This will have significant changes on the investment direction of foreign investors, and a drastic impact on the attractiveness of Japanese companies to investors.
“Foreign investors are working hard to quantify the cost of meeting the new requirements to inform their investment process moving forward,” said King. “Increased costs mean decreased profitability, so certain practices may come to an end. Those activities affected but still profitable will likely continue, but will create a compression in profitability.”
In terms of sectors affected, the focus will be on technology and telecommunications, such as semiconductor, integrated circuits, data processing services, and software development services.
Hiroko Jimbo, partner at Nishimura & Asahi added that in addition to the changes being implemented, the Ministry of Finance changed its ministerial notification earlier in 2019 to expand the designated business category for ownership notifications to include all software development and service businesses. “Combined with this business category change, the burden of pre-notification will increase dramatically,” she said.
Not only will investors need to notify the government of their investment plans, but these plans could be stopped should the government find them risky to national security. With the threshold dropping drastically from 10 to one percent, investments could easily be caught be the notification requirement.
How will the law impact activist shareholders?
According to Nicholas Smith, equity strategist at CLSA, hedge funds will be most affected by the change in law as it’s likely to limit their ability to influence company management and raise their costs of doing business.
There will be an increase in administration and compliance costs to comply with the notification requirement as more due diligence will be necessary when investing in Japanese businesses. When it comes to activism, filing at one percent will hurt investors most related to activism and these tend to be hedge funds. In the long term, the stocks of companies targeted by the law will suffer.
Japan has seen a growing trend towards shareholder activism in recent years as Prime Minister Abe continues to improve corporate governance. For instance, changes have been made to the Stewardship Code for businesses to increase engagement with investors and better manage conflicts of interest.
Shareholders, including foreign institutional investors, are increasingly asking questions about their long-term investments, such as disclosure of voting activities and the inclusion of company policies on potential and actual conflicts of interest. Yuki Kimura, director at Japan Stewardship Forum, an industry organisation with more than 80 members in the asset management industry, said: “The one percent threshold is simply too low and will discourage foreign investor involvement in Japanese companies. This is contradictory to the government’s ongoing efforts to increase corporate governance.”
What areas of the law lack clarity?
While the law will certainly be lowering the notification requirement to one percent, there remain a number of areas that lack clarity. “Definitions are still missing – for instance, the law doesn’t define what foreigner or investor means, and who will be given exclusions,” said Smith.
It’s also unclear whether the duration of ownership makes a difference, and whether there is a difference in the treatment of public versus non-public companies.
While the Ministry of Finance has announced that a number of companies will be exempt from the notification requirement, it is unclear what these will be until the Cabinet Order and Ordinance are released in May 2020.
How does it compare with similar laws in other countries?
The change is in line with the efforts of other countries – such as the US and Germany – to increase investment controls amid concerns that sensitive technologies and businesses are being taken over by foreign countries, such as China.
For instance, in the US, in 2018, the Committee on Foreign Investment in the US (Cfius) was given expanded jurisdiction to review foreign investments in the US, especially in sectors such as technology and critical infrastructure.
Smith believes that while Cfius reviews in the US are stricter, what is not expressly prohibited is still permitted. However, Japan will likely be taking a strong approach on the law’s implementation and the law will be interpreted more broadly.
King added: “I think the legislation will likely expand in the future using the US as a blueprint. Japan is a fiercely protectionist country, and such rules are necessary to maintain Japanese interests.”See also: National security investment clearances: what dealmakers need to know