Maximization of Corporate Value is the Best Defense Against Hostile Takeovers

The takeover battle for Nippon Broadcasting System Inc. (NBS) between livedoor Co., Ltd. (Livedoor) and Fuji Television Network Inc. marks a significant milestone in the history of Japanese corporate governance. The high-profile case, which attracted much media attention, demonstrated the threat of hostile takeovers has now become a reality in Japan. In this article, I would like to first summarize the changes in Japanese corporate governance since the 1990s and then to examine various defenses against hostile takeovers, which have become the subject of intense debates.

From the postwar period to the 1980s, major creditor banks played a critical role in ensuring good corporate governance in Japanese companies under the "main bank system." Since the 1990s, however, significant changes have occurred in this governance mechanism. First, the main bank system is no longer able to provide a governance mechanism (typically by bailing out troubled corporate borrowers) because of the severe deterioration of the banks' own financial health under the enormous burden of nonperforming loans. At the same time, banks have accelerated moves to dissolve cross-shareholdings with borrowing companies.

Consequently, the percentage of stable shareholders (those holding shares for the sake of long-term business relationships) fell by half in the past 10 years to about 25%. On the other hand, foreign ownership of Japanese companies, which used to account for only several percent, has now risen to some 20%. That is, a substantial number of shareholders are interested in rising share prices, rather than in maintaining business relationships with investee companies.

A series of revisions to the Commercial Code and other relevant laws and regulations since the 1990s also represents a major change in the corporate governance environment. Along with the introduction of the mark-to-market accounting method and the consolidated accounting system, a range of new rules and measures has been implemented to facilitate organizational restructuring, increase corporate financing options, and reinforce the monitoring functions of directors and others. Specific changes include the introduction of share buybacks and stock options, the establishment of holding companies, the equity-swap system, and measures to facilitate corporate takeovers. As a result, more options for corporate governance are now available. The most important change, however, was the revision of rules for shareholder derivative actions in 1993, which enabled shareholders to file lawsuits for a low, fixed fee. This lowered cost of litigation led to a sharp rise in the number of shareholder derivative suits; thus the risk of directors being sued by shareholders has become a reality. This is a significant change in the sense that it implanted the idea in the minds of Japanese corporate managers that they cannot ignore the interests of shareholders in their management decisions.

Thus, while pressure for shareholder-oriented management has increased remarkably, both in substance and institution-building, a new mechanism of governance has yet to emerge to take the place of the main bank system, resulting in an ongoing "governance vacuum." Against this backdrop, a "quasi-takeovers" - i.e., takeovers of management by people outside the company's main line of business - took place in many companies, even those that have performed well, since the mid 1990s. For instance, Hiroshi Okuda, now chairman of Toyota Motor Corp., had little experience in the automaker's mainstream business, with his career centering on overseas operations prior to his appointment as president in 1995. In his new position he carried out bold, unprecedented reforms and succeeded in boosting the company's business performance. Such internal governance mechanisms with a self-purification function, as exemplified by the aforementioned quasi-takeover, are deeply rooted in the evolving corporate cultures of many companies in recent years. But this process takes time: Even a listed company cannot create such mechanisms overnight.

What is important for Japan, which is in a transitional stage in the development of its corporate governance, is to satisfy, both in substance and institution-building, the requirements arising from the ongoing shift toward shareholder-oriented management by: (1) increasing the role and presence of highly-independent outside directors; and (2) utilizing takeover threats as leverage to enforce discipline. With respect to outside directors, Japan must start by understanding their importance and having them take root in the Japanese system. A revision to the Commercial Code has enabled major companies, starting in April 2003, to opt for an American-style organizational structure of governance, which mandates the establishment of three committees: the nomination committee, the audit committee and the compensation committee, under the board of directors, with each having a majority of outside directors. For the moment, however, reality has yet to catch up with this institution-building process as only a handful of companies have actually shifted to such a governance system. What is necessary is to create a self-reinforcing governance mechanism within companies that have adopted the committee system. The functions of such a system are described below:

1. Outside directors' judgment improves the management of a company.

2. Investors and market players value the improved management of the company which, in turn, enhances the reputation of companies that opt for the new governance structure.

3. As more companies opt for the new governance system, there is an increase in the demand for capable outside directors, which creates a market for outside directors.

While the conventional structure based on cross-shareholdings and stable shareholders is crumbling, potential buyers have enjoyed a large volume of liquid assets. Thus, corporate takeovers are easier than they used to be and concerns about the threat of hostile takeovers are mounting on the part of potential target companies. However, these companies are takeover targets because of their own failure to maximize corporate value, thereby presenting themselves as a "good buy" in the eyes of potential buyers. Furthermore, the value of these companies may increase under new, more capable managers. This is the basic mechanism of corporate takeovers and the threat of such takeovers imposes discipline on corporate managers. Given the current state of corporate governance in Japan, where the idea of protecting shareholder interests has yet to take root and where a new governance mechanism has yet to emerge to take the place of the main bank system, both the government and companies should be cautious in introducing takeover defenses. With respect to "poison pills," which have drawn much attention as a means of avoiding hostile takeovers, the pluses and minuses of introducing such a scheme hinge on whether the means of removing the poison pill in the case of a "good" takeover are also put in place. In Japan, decisions and proposals made by the management tend to be endorsed by outside directors as well as in proxy fights. Even if shareholders bring a case to court, as in the United States, it will take some time for Japan to develop legal predictability in its court judgments. The best and most effective defense against hostile takeovers is the maximization of corporate value, and there are no gimmicks or tricks to it. I do hope companies that understand the importance of not introducing takeover defenses measures too hastily will be rewarded by the market.

>> Original text in Japanese

* Translated by RIETI.