Shareholders' Interests Key in TOB Defense Debate

Faculty Fellow, RIETI

Co-authored with HATTORI Nobumichi*

Even a hostile takeover bid succeeds only when the bidder wins the support of a target company's shareholders. In this light, the prevailing argument on the threat of unsolicited bids for Japanese corporations by foreign companies is exaggerated. The government ought to be cautious about authorizing "poison pill" and other preventive measures, steps that risk impairing the interests of existing shareholders.

Debate is growing on hostile takeover bids and the defenses against them. The government is considering approving triangular mergers in which an acquiring company uses its shares to pay for the purchase of a target company, when the Commercial Code is revised next year. The step will facilitate acquisition by foreign companies of Japanese firms, raising concerns that as a result, unsolicited takeover bids could proliferate.

Lifting the ban on the triangular merger is an extension of the Japanese-style stock exchange system introduced in the 1999 amendment to the Commercial Code. Until then, few statutory means existed in Japan to return a public corporation to a close corporation.

Western countries largely allow acquisitions through stock swaps. The U.S. has an established triangular merger system under which a target company is merged into a subsidiary formed by an acquiring company for the merger, and the acquiring company allocates its shares to the shareholders of the target firm as consideration for the purchase, making the target company its wholly-owned subsidiary.

In many European countries, a takeover bid using an acquirer's shares as consideration for the buyout is permitted. If the bidder can garner 95% or a majority of shares in a target firm, it is typically allowed to force the remaining target shareholders to sell their shares to the bidder.

Framework needed

Given no such frameworks, Japanese companies had long demanded statutory steps to turn affiliates and subsidiaries into 100% subsidiaries - as well as to create a holding company which owns 100% of subsidiaries - resulting in the realization of the Japanese-style stock swap system in 1999. However, the procedure is only allowed to apply for a merger between companies formed based on Japan's Commercial Code, barring the involvement of foreign corporations.

Meanwhile, the U.S.-style triangular merger or European-style TOBs are applicable to cross-border stock swaps. In the circumstances, foreign companies have pressed the Japanese government to allow them to acquire Japanese firms through stock exchange, prompting the government to mull authorizing the triangular merger.

The stock-for-stock merger makes acquisition easier, eliminating the need to raise funds for the transaction. Leading Western corporations have by far the greater amount of market capitalization than Japanese counterparts. The market value of P&G of the U.S., for example, is 15 trillion yen ($141.5 billion), about 10 times that of Kao Corp., Japan's top household product company. The fact has stoked fear among Japanese businesses that the approval of the triangular merger could result in a flurry of uninvited TOBs by foreign corporations against Japanese ones.

No doubt, it would not be easy for even a huge company boasting 10 trillion yen-plus in market capitalization to procure 1 trillion yen or more in cash at a stage when the success of a TOB is still uncertain. In the U.S. or Europe, the larger the bid the more acquirers opt for stock swaps.

Now, will the approval of the triangular merger really turn Japan into a TOB heaven for Western corporations? Hardly. The step will likely remain unusable, with a deferred-tax system unavailable in Japan. Since shareholders of a target company are levied a capital gains tax on shares they received from an acquiring corporation at the time of receipt, not the time of the sale of the shares, the shareholders would balk at swapping their shares with those of the acquirer.

Should shareholders of the target corporation agree to exchange shares, the shareholders would most likely rush to sell the stock of the acquiring company to finance the tax payments, sending the acquirer's stock price tumbling.

Merger currency

As shown in the graph, 40-70% of mergers and acquisitions undertaken in the world in terms of value use stocks to pay all or part of consideration. M&As comprise a majority of foreign direct investments in industrialized countries. The Japanese government should introduce the tax-deferred system if it is to achieve its goal to double foreign direct investments in Japan, although the Ministry of Finance is reportedly examining the possibility of the step.

It would not be entirely bad if the tax-deferred system is put in place and the triangular merger becomes usable, whereby prompting foreign companies to acquire Japanese firms. A company tries to buy out another company only when it judges that the target firm will be able to create value above the acquisition premium paid by the acquirer to the acquired. The creation of value is possible in two cases: Executives of the target company have neglected to maximize shareholders' value or the acquirer believes that combining its own business resources with those of the acquired will produce a greater value. For either case, uninvited M&As are desirable. An acquisition resisted by the management of a target company is not necessarily detrimental to shareholders of the firm or the overall Japanese economy.

An analysis found that many M&As by foreign companies of Japanese firms improved the productivity of the acquired companies. When a firm on the verge of collapse is purchased, the work force of that company is typically slashed. But even if the company is not acquired, it might fail and employees could lose their jobs anyway. Also, the argument that foreign companies often buy out Japanese firms in a bid to obtain Japanese technology at low cost is not well-grounded either.

The largest hostile acquisition was that of Mannesmann of Germany by Vodafone of the U.K. The emerging British mobile phone carrier succeeded in winning the support of shareholders of the German mobile phone company, which ran the cutting-edge business like a smokestack factory.

Even an unsolicited buyout deal would not be struck without the backing of the target company's shareholders, and when the acquirer obtained the support of the target shareholders the hostile deal would turn into a friendly transaction.

Meanwhile, an acquirer sometimes splits a company it purchases through a hostile bid into units and sells them to a number of buyers. Some maintain that this harms companies as social assets. In reality, many strategic hostile acquirers have succeeded in securing the support of target shareholders, and strove to create greater value. Also, just the threat of hostile TOBs helps improve management discipline.

A TOB by a U.S. buyout fund for Yushiro Chemical Industry Co., which made headlines earlier this year, was something quite different. The fund eyed the considerably low ratio of the firm's operating profit to its aggregate corporate value including the firm's ample cash on hand. It reckoned that the firm's stock price would not fall even if it had the firm drain the cash in the form of special dividends, since the stock price did not reflect the hefty cash on hand, as the firm's price-earnings ratio was on par with other companies in the same industry.

Shady play

The bid failed as the Japanese company boosted dividend payments to discourage shareholders from selling the shares to the fund. But the fund apparently had no intention of taking a controlling interest in Yushiro. Rather, its purpose was very close to greenmailing, or quick profit-taking.

Investment funds, like the one which launched the TOB for Yushiro, do not issue shares to be used in a triangular deal. So the triangular merger approach will likely be adopted by major foreign companies which want to acquire Japanese corporations in the same business line. In that case, the acquirer's stock is required to be traded on the Tokyo Stock Exchange's foreign section to ensure the liquidity of their shares. This would help vitalize the TSE's foreign section.

In the case of Yushiro, if the company had not decided to sharply increase the amount of dividend, the bidder fund might have been able to acquire the firm, initiate a huge one-time dividend increase which would have drained all the cash on hand, and then unload its shareholdings. For such TOBs, which could do great damage to the interest of other shareholders, companies should be allowed to resort to countermeasures.

But the U.S.-style poison pill risks hurting the interests of existing shareholders as well unless it is used correctly. Because of the risk, U.S. authorities only allow a target company to use the step as a bargaining tool to adjust terms of a buyout proposal in favor of the target shareholders' interest. Companies are prohibited from using the measure to foil TOBs.

In discussing defensive steps against hostile bids, the Japanese government should give full consideration to this aspect so that the management of a target company cannot use the countermeasure to protect their interests at the expense of shareholders.

*Nobumichi Hattori is a visiting associate professor at Hitotsubashi University.

>> Original text in Japanese

* The article was reprinted from The Nikkei Weekly, November 15, 2004. The original article appeared as "Keizai Kyoshitsu" column in Nihon Keizai Shimbun, October 26, 2004. No reproduction or republication without written permission of the author, Nihon Keizai Shimbun and The Nikkei Weekly.

November 15, 2004 The Nikkei Weekly

November 24, 2004