Is the Poison Pill Good for Japan?: A Preliminary Analysis of the New Takeover Guidelines

Date July 28, 2005
Speaker Curtis MILHAUPT(Professor of Law, Columbia Law School)
Moderator TSURU Kotaro(Senior Fellow, RIETI)


My talk today is based on a paper I am currently writing entitled "In the Shadow of Delaware? The Rise of Hostile Takeovers in Japan." I want to begin by highlighting two extraordinary facts: First, Japan today is riveted by a series of hostile takeover attempts, one ongoing as we speak. Second, the Corporate Value Study Group Report and to a somewhat less extent the Takeover Guidelines issue by METI and MOJ represent a remarkable endorsement of Delaware takeover jurisprudence developed in the late 1980s. Indeed, there are many interesting parallels between the United States of the 1980s and Japan of the early 2000s in terms of legal and market development in the realm of hostile takeovers.

My approach is to follow some very powerful ways of understanding how Delaware takeover law evolved, and to apply those insights to Japan. One way of looking at the Delaware takeover law, the development of the poison pill, and judicial responses to the poison pill, is to see them as a series of strategic and adaptive responses to market change. Market change exposes gaps or problems in the law, causing market actors to respond in order to exploit or rectify those legal problems. Those responses, in turn, often present new questions that must be answered by someone. In the United States, the courts took the lead in answering questions raised by hostile M&A activity, such as who should have the power to determine whether an unsolicited bid should be put to shareholders. Market players then adapted to the rules developed by the courts. Eventually, the United States arrived at a rough equilibrium in which the poison pill operates. Although there is obviously still controversy about how well it operates, most people would agree that the poison pill works fairly well as a tool to enhance shareholder value and not simply as a tool to entrench or protect corporate management.

A second approach that I take in understanding the development of Delaware law is to look at the interests of the people who are involved in this process of strategic adaptation (lawyers, judges, etc.) and to see how the law may have developed in the interest of those players.

Drawing parallels to the process of legal and market adaptation in the United States in the 1980s, much the same forces are at work in Japan at a broad level. Changes in the market (the implosion of Japan's bubble economy) exposed problems in corporate law and corporate governance, and people responded. They did this by pursuing legal strategies (e.g., dramatic increases in shareholder derivative litigation and amendments to the commercial code), opting out (e.g., Sony shrinking its board) or pushing the envelope (e.g., Livedoor CEO Horie launching a bid for Nippon Broadcasting). Eventually, at least in the United States, this type of activity led to a new system of corporate governance, which was much more market-charged. Along the way, it also led to the creation of the poison pill and the legal doctrines that Japan is now borrowing. M&A appears to have an important catalyzing effect on institutional structures, so I see much the same process playing out in Japan.

Turning to the METI/MOJ Takeover Guidelines and the Corporate Value Study Group Report on which they are based, it quite remarkable the degree to which policy makers approved of "Anglo-American measures" as a global standard, and more expressly approved of Delaware takeover jurisprudence as a suitable policy for Japan. Many of the principles enunciated in the guidelines come directly from cases in the United States such as Unocal, Unitrin, Revlon and Toll Brothers. For example, Unocal basically says that in erecting defensive measures, management should be responding to some threat to corporate policy and effectiveness and not primarily to protect themselves in office. Similarly, Unitrin emphasizes the shareholders' right to replace the board of directors as their critical protection against overly broad defensive measures. "Revlon duties" are the obligations of the directors to step aside in effect and become an auctioneer for the firm when faced with competing bids for control of the firm. Finally, Toll Brothers was a case that struck down what is known as a dead-hand poison pill which effectively forecloses the opportunity for shareholders to replace the board and eliminate the pill. Each of these basic principles finds some parallel in the Japan's new Takeover Guidelines.

The Corporate Value Study Group noted that Japan faced a high transaction cost environment with respect to defensive measures and pointed out that most developed countries allowed some form of defensive measures, while Japan had none. They scoured the globe to see what other countries are doing and generally speaking endorsed Delaware as a market-tested and well-understood "global standard." One could argue that the City Code would have been more appropriate as it is more administrative, less court-centered and a simpler and more streamlined approach. There are probably many reasons why the Delaware approach was basically favored over the City Code approach. But here are a few interesting ones, at least as far as my analysis would suggest: One third of the Corporate Value Study Group members are lawyers or law professors trained in the United States, and thus the Group was more familiar with Delaware law than with the London City Code. Interest group dynamics were also at work: The poison pill represents a huge new business opportunity for Japanese lawyers, and potentially even for U.S. lawyers and financial advisors. Indeed, METI retained a U.S. financial advisor and U.S. law firm to explain their policy to the outside world. And as noted above, operating through non-binding guidelines as opposed to legislation places METI in a central role of a critical area of industrial policy.

It is obviously too early to fully assess the implications for Japan, but three general scenarios are possible: One, strong-form convergence with the United States, which would involve the development of an active market for corporate control, heavy involvement by independent directors in structuring deals and defensive measures, and a central role for the courts in resolving disputes. The contrary scenario, what I call "cryonic suspension," is that the poison pill will prove too powerful a defensive device given Japan's institutional structure, serving as a substitute for cross-shareholding and stable shareholding. In this scenario, everything will be frozen in place. The third scenario, which to my mind is the most likely, is a kind of unpredictable trajectory from here as Japan tries to transplant and adapt a very unfamiliar body of law to its own circumstances.

There are several grounds for pessimism concerning the question of whether the poison pill is good for Japan. First, legal transplants are highly unpredictable. History is littered with examples of countries that thought they were following one objective in adopting a foreign statute or procedure but ended up with something else altogether. In this case, Japan is not trying to adopt a specific rule, they are trying to adopt 20 years of highly complex judicial doctrine developed at a very different era in the U.S. That is an extraordinary experiment, and it is not clear how it will turn out, particularly because the Delaware law itself is vague, highly fact-specific and gives a lot of discretion to the courts to do what is "fair."

Second, the lesson from the United States is that the surrounding institutions are extremely important. It is fair to say that the infrastructure of complementary institutions that exist in the United States, including independent directors, the SEC, a robust capital market, expert and centrally involved corporate law courts, etc. is much strong and more highly developed than in Japan.

Thirdly, the specter of political intervention is still very high. If court cases on defensive measures continue to be decided against corporate management and in favor of the bidders, one can anticipate more pressure to create some kind of legislative response.

But there are also grounds for optimism. The express purpose of the study group and the guidelines was to create consensus in Japan on takeover defenses. This already appears to be happening. The discussion about corporate value, shareholders as ultimate owners of the corporation and the role of independent directors is extremely healthy. It is possible that this debate will spill over into other areas of corporate governance and help change the way that people think about these issues. Finally, the biggest reason for optimism is that the courts are now a dramatic new player on the corporate governance scene in Japan, having proven themselves very capable of rendering decisions in sophisticated transactions quickly and accurately. To my mind, the courts have reached the right decisions in the cases so far.

If shareholders are willing to sue in the face of defensive devices that they think are overreaching by management, and if the courts can discern reasonable defensive measures designed to protect shareholders and enhance corporate value from those that are designed to protect management, then things will work out well for Japan.

Questions and Answers

Q: You stated that the City Code is more suitable for Japan, but there has been little discussion about the relative advantages and disadvantages. Which is better as a regulation on defensive measures: a U.S.-type poison pill or UK-type City Code? Also, since the guidelines were published, there have been some signs of change and activism. How do you judge the Japanese courts reaction to such cases as Livedoor or should they be practicing more jurisprudence?

A: One thing that is very important with respect to the poison pill is that in the United States, there is a difference between putting the pill in place in "peacetime" when there is no bidder on the scene or putting a pill in place, or keeping it in place, once a bid has been launched. What is not well understood is that under Delaware law, even if a company has a pill in place they must re-evaluate the fairness of keeping the pill in place in the face of a bid. That is often lost in the debate in Japan, but what this means is that management has to identify a threat posed by the bid. Given that Delaware law, much more than the City Code, is fairly protective of managers, this test to prove a threat is not particularly difficult to meet. Nonetheless, management is forced to explain its actions.

In terms of jurisprudence, in reading, for example, about the Livedoor case, it is very obvious that the court was looking at and being influenced by a draft of the guidelines and the report. The decision, however, in some ways went beyond the guidelines. This suggests that the courts are looking to expand their role. I think the impact of the guidelines remains to be seen. These are non-binding guidelines which can be overridden by the courts and legislature, so we are just in the beginning stage of the process. It is very likely that we will see an accumulation of rules.

Q: What are some objective measures that could be taken to deal with the infrastructural weakness in Japan to cope with such mechanisms as the poison pill?

A: On shareholder approval and the proxy process, there might be some grounds for optimism that the proxy contest could work. It is not feasible under Japanese corporate law to stagger the board, which is very common in the United States. To have a staggered board and a poison pill is an extremely powerful defensive mechanism in the United States. To the extent that this is not possible in Japan is a good thing and suggests that if the proxy process could be reformed, maybe there is some room to make this work.

Creating objective guidelines to discern good from bad takeovers is a good idea in principle but probably extraordinarily difficult to do in reality. One of the reasons that the study group emphasized Delaware law is that they think that potential judicial error is outweighed by the ability of the court to step in flexibly and make the determination on each case. The reality is that people will always innovate around the legal rules, so whatever standards you may have, people will find ways to make bids that do not fall within those guidelines.

As for independent directors, there is room for improvement in this area and it would be a good idea to have more clarity about what an independent or outside director is.

Q: It seems to me that some of the laws regarding how proxies are counted and disclosed are open to manipulation. Is it correct to understand that proxies do not need to be audited by an outside auditor? Also, there are complaints about how proxies are mailed out and that foreign investors do not have enough time to mail their votes in.

A: The clear consensus among foreigners active in the Japanese market is that there are serious logistical problems with the proxy process that hinder informed and timely voting by foreign institutional investors. I am not aware of any audit requirements for proxy votes.

Q: What is interesting in the M&A situation and the debate surrounding it is that it is all about hostile public company situations, but almost 100% of the M&A market here is not hostile and involves a lot of private transactions. What aspects of the governance system would be most helpful to address that majority part of the M&A market?

A: My sense is that there has been improvement in the legal infrastructure for M&A over the last ten years. One way in which this debate about hostile activity could be useful to the general transactions would be focusing the point on management's fiduciary duties, their meaning and to whom they are owed.

By focusing on the proper role of the board, the debate on hostile takeovers can be useful to friendly transactions. I am not aware of any major technical obstacles to doing M&As in Japan, so it is more of a problem with how management thinks about M&A and what it means to maximize corporate value.

Q: How do we create a market for independent directors? Also, there are a few people who are famous for their ability as outside directors, but they have no time to serve for several companies. Furthermore, the word "independent" seems a bit vague.

A: Currently there is no requirement for independent directors in Japan. The Japanese commercial code uses the term "outside" director, and the definition is broad enough to include directors who are not independent of the firm. So the legal requirements could be enhanced. I do not really buy the argument that there are no suitable people in Japan who could serve as outside directors. Drawing on the U.S. experience, there was some very strong incentive from the courts for creating independent directors, and that suggests one possibility for Japan. Also, after Sarbanes-Oxley the New York Stock Exchange and NASDAQ revised their listing standards to contain a much stricter definition of independence, suggesting that the Tokyo Stock Exchange could get involved in clarifying the definition and requirements for independence. There is room as well for shareholders to play a role in encouraging more independent directors. But first and foremost, there has to be a will to create a market for independent directors.

Q: From the experience in the United States, are there things that could be adopted in Japan which would give pension funds greater say in corporate management questions?

A: The pressure on the pension funds to generate returns is having an impact and is driving some of the trends toward greater involvement in corporate governance. It is interesting to look at the Pension Fund Association and the way that they have changed over the last several years. My sense is that the pressure has caused them, albeit reluctantly, to start to get involved corporate management issues. They voted against all except one of the shareholder rights plans at the meetings this season. Similarly, I have heard that the concentration of shareholder meetings in June is a problem for the pension funds because they cannot attend all of them, so spreading out the meetings may be useful. Of course some companies may schedule their meetings to preclude participation by institutional investors. Increasing the involvement of institutional investors in the Japanese market is a very important issue, but it strikes me not so much as a legal issue but as a mindset issue.

Q: Have there been a lot of cases of management buyouts in the United States?

A: Management buyouts were a very common tactic in the 1980s. They are not as prevalent today, but they are a very common structure for taking a company private.

Q: With respect to the Livedoor case, particularly the Murakami fund, compared with corporate investors, the fund did not need to disclose detailed information on its partners. The Financial Times reported that the UK City Code will implement some regulations to disclose information on fund managers. In Japan, similar regulations are being studied. What do you think about this situation differing from the U.S. standard?

A: I do not have any specific opinion about it. I take it that you think that it is much better if the limited partners had to disclose their interests. In general, Japan could do with much better and more robust disclosure across the board, so in keeping with that, this may be an area where there could be better disclosure.

Q: Could you elaborate on your thoughts about the role that METI or for that matter other government institutions could play in trying to influence the courts to come up with clearer guidelines for corporate law?

A: Both METI and MOJ have played interesting roles in connection with the takeover debate. The Ministry of Justice's role is interesting because although they have formal jurisdiction over corporate law, they were kind of a silent partner of METI in the process of formulating the guidelines. Also, MOJ chose to use guidelines instead of seeking to draft legislation, as they typically do. METI has no formal jurisdiction over the corporate law, but its involvement is consistent with the major role the ministry has played in corporate governance policy over the past decade. Not coincidentally, METI's involvement in the drafting of the guidelines this places them at the center of these developments going forward-a role they may not have played if a legislative response had been chosen.

Q: One problem at METI was that many Japanese companies do not have experience with litigation, so would you think that is one of the infrastructural weaknesses in Japan that would also call for a bigger involvement of METI than MOJ?

A: An area of potential conflict is that the guidelines, which are heavily influenced by Delaware law, are borrowing from a system that is very court-centered, which Japan is not. It is not obvious to me why METI would be at the center of the guideline process, other than the fact that they are close to industry and this is an important area of economic policy. I think it is a very smart move for them in the sense of remaining relevant and at the center of important action. Maybe it is good that Japan decided to operate through guidelines, because perhaps they will achieve the stated goal of cementing a consensus on what constituted fair and reasonable defensive measures. I think it is too early to say whether they have been successful.

In speaking with METI officials about why Japan primarily opted for Delaware law as opposed to the City Code, one response is that the mandatory bid rule was not seen to be advantageous for Japan, because if you have to make a bid for all outstanding shares, it could be expensive and diminish the amount of hostile takeovers. They also saw the adoption of a mandatory bid rule as a regulatory response, when Japan is trying to deregulate. I am not sure I would agree with that, but they did have a rationale for why they adopted the Delaware approach.

Q: In the United States, are there any cases in which shareholders go after independent directors or is there any legal protection for directors?

A: There are many cases of shareholders suing a director seeking to recoup damages to the firm. The shareholders lose most of the time and there are a variety of techniques developed by boards to choke off this type of litigation. The interesting developments recently are the Enron and WorldCom settlements, where the plaintiffs insisted that the directors, including outside directors, pay into the settlement out of their own pockets. That is a remarkable development in the United States because up until that point directors were largely shielded from personal liability through insurance, indemnification, etc. We will have to see what the impact of the watershed Enron/WorldCom settlements is on director behavior and willingness to serve on the board.

Q: There is quite a big gap of understanding between those investors who are retired "pure" investors and those who are still working. Who should speak for individual shareholders because it is mostly public bodies that are active in Japan?

A: As a parallel, in the United States it is actually the public pension funds that tend to be more active, for example, the California Public Employees' Retirement System (CalPERS). It is true that the independent directors, being former managers, share a managerial mindset and that problem needs to be overcome, so these are issues that should be addressed. To the extent that institutional investors are operating usefully in the UK, that may be a model that Japan would want to look at.

Q: What do you think is the future direction for Japanese corporate governance and who will play an important role?

A: The poison pill in the United States did not stop takeover activity. The poison pill forces the bidder to negotiate with the target company's board, but it does not simply lock up the existing management. I hope that the situation will develop similarly in Japan. I do not expect the market for corporate control in Japan to ever play the role that it does in the United States, but I think it would be extremely healthy for it to play some role.

*This summary was compiled by RIETI Editorial staff.