How to Cope with the Threat of Hostile Takeovers: Japanese Corporate Governance at a Crossroads

TSURU Kotaro
Senior Fellow, RIETI

Introduction

The takeover battle for Nippon Broadcasting System Inc. (NBS) between livedoor Co., Ltd. (Livedoor) and Fuji Television Network Inc. is a milestone in the history of Japanese corporate governance. First, the high-profile case, which attracted much media attention, demonstrated that the threat of hostile takeovers has become a reality in Japan. Second, it provided an opportunity for Japanese to rethink the relationship between companies and their shareholders. It has long been believed that hostile takeover bids would have a little chance of succeeding in Japan. Why has this changed and what factors have turned the threat of hostile takeovers into a reality? Some argue Japan needs to introduce a "poison pill" defense as a means to counter hostile takeover bids. In this article, I will assess such defenses in view of Japanese institutional infrastructure, as well as from the standpoint of law and economics.

Factors that have made the threat of hostile takeovers a reality

One big factor behind the looming threat of hostile takeovers is the rapid dissolution of cross-shareholdings that began in the 1990s, in particular, between creditor banks and corporate borrowers. As a result of this unwinding, the share of stable shareholders (those holding shares for the sake of long-term business relationships) fell by half over the past 10 years to about 25% of the total. On the other hand, foreign ownership of Japanese companies, which used to account for only a few percent of all shares outstanding, has now risen to some 20%. The proportion of free-floating shares has thus risen significantly. This also means that buying out a company by means of tender offer bids (TOBs) has become far easier.

Another factor is the large amount of liquid assets held by many Japanese companies. Since the 1990s, companies have stepped efforts to get rid of their debt overhang and to cope with banks' declining risk-taking capacity. Companies that have large liquid assets have demonstrated resilience against financial risks at a time of distress in the nation's financial system. However, an increase in the amount of liquid assets leads to a relative decrease in a company's price to book-value ratio (PBR = aggregate market value / net book worth), making the company an easier takeover target.

The role of takeovers

Against this backdrop of easier corporate takeovers, potential target companies are becoming increasingly concerned about the possibility of hostile takeovers. However, it is not appropriate to try to eliminate all hostile takeovers. Where companies have become a target because of their own failure to maximize corporate value, it is quite possible that corporate value will increase under new, more capable managers. Furthermore, because the success of a (hostile) takeover - from the viewpoint of incumbent managers - means a loss of status, the threat of a hostile takeover gives them an incentive to increase corporate value so as to prevent such a takeover. In Japan, the vacuum in governance left by the collapse of the so-called main bank system has yet to be filled by a new system that can penalize poorly performing mangers. Given this reality, the presence of a "threat-driven" disciplinary mechanism (i.e., exposure to the threat of hostile takeovers) is very important.

Of course hostile takeovers have a downside. It is often pointed out that a hostile takeover sometimes ends up undermining the competitiveness of the purchased company because implicit contracts between the company and its stakeholders are effectively nullified ("breach of trust"), thereby reducing incentives for certain kinds of investments - those that are possible only when corporate managers are supported by such implicit yet sound relationships with stakeholders. This argument may provide a good explanation of the United States' loss of industrial competitiveness in the later half of 1980s, when a storm of hostile takeovers swept the country. But the subsequent experience of the U.S. indicates that a wave of mergers and acquisitions (M&As), including hostile takeovers, brought about the thoroughgoing restructuring or dissolution of inefficient conglomerates that had been built in 1960s and afterward. This process of "selection and concentration" laid the foundation for the revival of and structural change in the U.S. economy in the 1990s. In this context, if Japanese companies are to enter a new frontier, they must proactively utilize the takeover mechanism as a means to break from the past and realize true restructuring, rather than trying to maintain amicable relationships with stakeholders.

Assessment of the government's Guidelines for takeover defense measures

The most effective defense against hostile takeovers is the maximization of corporate value. However, many companies, particularly those feeling a greater sense of threat, are hoping to introduce takeover defenses. And it was against this backdrop that the Ministry of Economy, Trade and Industry and the Ministry of Justice issued the "Guidelines Regarding Takeover Defense for the Purpose of Protection and Enhancement of Corporate Value and Shareholders' Common Interests" (hereafter "the Guidelines") in May 2005, a document aimed at creating rules for takeover defenses. Japan's corporate law has been reformed with a deliberate eye on U.S. law, thereby laying the groundwork for the introduction of poison pill type (rights plan type) defenses, such as are available in the U.S., to guard against takeovers. How should we assess these developments?

First, it is commendable that the Guidelines are intended to preclude the use of excessive defenses - and not to help incumbent managers entrench themselves in office - because Japan's corporate law, as it stands today, would otherwise allow for the use of any defense permitted under both European and U.S. corporate law. The Guidelines give specific examples of defenses, along with conditions governing their use. Companies should recognize that these conditions are presented as "necessary but not sufficient conditions" from the standpoint of legality and reasonableness. For instance, in cases where a board of directors attempts to introduce a poison pill, the legality of such a move hinges on whether or not there exists a mechanism that can reasonably eliminate the poison pill when a "good" takeover proposal - one that would increase corporate value - is presented. In this regard, the Guidelines call for provisions enabling the cancellation of the poison pill by shareholder vote, for instance, through proxy fights. Also, in order to prevent abuse or arbitrary use of takeover defenses by boards, the Guidelines urge that objective criteria be established for automatic removal of the poison pill (e.g. automatic removal of defenses after a specified period for assessment or negotiation) or, if no such objective criteria are in place, that a mechanism be set up to give priority to decisions by outside directors or a special committee exclusively composed of outside directors.

However, determining the independence of outside directors is inevitably subjective and each company must make its own judgments on a case-by-case basis. That is, the takeover defenses introduced in the Guidelines are not intended to be options whose legality is automatically guaranteed as long as companies meet certain conditions. According to the Guidelines, a measure adopted based on shareholder approval has a higher degree of legality than the one taken by a decision of the board of directors. But shareholder approval per se does not guarantee the legality of a takeover defense measure because the legality of a measure also depends on its substance. Only the courts can render decisions on the ultimate legitimacy (legal "sufficiency") of a poison pill or any other takeover scheme; such decisions are likely to be extremely difficult in some cases.

Differences in institutional infrastructure between the U.S. and Japan

The Guidelines inadvertently highlighted the fact that Japanese companies face a very high hurdle (e.g., proof that decisions of the board of directors are not arbitrary) in setting up rational poison pill defenses. This is because the U.S. institutional infrastructure supporting poison pills differs considerably from that of Japan.

First, the relationship between shareholders and management is quite different in the two countries. In the U.S., where shareholder-oriented management is well established, corporate managers have long faced pressure from shareholders to maximize their interests. Particularly since the 1990s, institutional investors such as pension funds have been aggressive in making demands of corporate managers. The relationship between such influential shareholders - those who have a say in the running of a company - and shareholder-conscious corporate managers is an indispensable feature of the U.S. system because poison pills are by nature a pro-management scheme. Most U.S. companies are incorporated in the state of Delaware and the legality of poison pills has been developed through Delaware case law. At the same time, however, it is often pointed out that the rules for takeover defense measures have a pro-management bias, reflecting the state's desire to attract as many companies as possible to generate tax revenue. Therefore, the presence of active shareholders who will monitor the behavior of corporate managers and take action if necessary is all the more important in order to maintain proper balance in the system.

Analysis of American companies that have adopted poison pills shows that the presence of such defenses, while having little effect on the probability of hostile takeovers, tends to give the company leverage in its negotiations with potential buyers, thereby boosting the premium on the corporate value, and hence increasing the final sale price of the company (Comment and Schwert 1995). In other words, a poison pill is a type of negotiation tool to extract more money from the buyer and bring greater profits to shareholders, rather than a device that enables corporate mangers to save their own necks. In Japan, by contrast, general shareholders who have no direct business relationship with the company have little influence over management. Thus, even if a takeover defense measure is made subject to approval at general shareholders' meeting or in a proxy fight, there is a high probability that the resulting decision will turn out to be pro management and detrimental to general shareholder interests.

Second, independent outside directors constitute a majority of the board in many American companies. It is understood that if problems arise these outside directors, who represent shareholder interests, will intervene and demand changes, including replacement of the CEO, and that they will play a leading role in any decision on a hostile takeover proposal. In Japan, the need for independent outside directors and their role are not yet sufficiently understood. It will likely take time for the outside director system to take root in Japan and for a market for such outside directors to develop. The revisions to the Commercial Code taken effect in April 2003 enabled major companies to adopt a "committee system," a U.S.-style structure for corporate governance. Companies adopting the new system must establish three committees - nomination, audit and compensation - under the board of directors, with each committee comprised of a majority of outside directors. Even with the institutional framework in place, however, the system has yet to take hold; at the moment, only a handful of companies have shifted to the committee system.

Third, the role of the judiciary in the U.S. is quite different from that of Japan. The 1985 ruling by the Delaware Supreme Court in Unocal Corp. v. Mesa Petroleum Co. was a precedent-setting case in terms of judicial review of the legality of takeover defenses. The Unocal decision, however, is not intended to be an absolute standard. U.S. court decisions on the legality of takeover defenses measures are hard to predict because the standard applied is flexible. In other words, "poison pill law" in the U.S. has been established gradually through case law in order to provide practical rules for takeovers. In the case of Japan, the Guidelines, as mentioned above, do not provide a definitive foundation of legality, and therefore determination of the legality of each specific takeover measure is left to the courts. This, however, means requiring the Japanese judiciary, which is strongly influenced by the Continental (German) legal system and seeks to apply the law to formally enacted statutes in judging specific cases, to fulfill a legislative function, as is the case under the Anglo-American common law system. Writing takeover rules through the accretion of judicial decisions was no easy for the Delaware courts, the commercial court system with the most takeover experience of any in the world. Considering this, the task imposed on the Japanese courts - judging the legality of takeover measures without legislative guidance - will be extremely burdensome (Gilson 2004).

An empirical study on the transplantation of the comprehensive legal codes of a developed country into a developing country has shown that foreign institutions do not take root if the surrounding infrastructure remains incomplete (Berkowitz, Pistor and Richard 2003). Thus, in the case of Japan, it is hoped that the importance of independent outside directors and active shareholders will be recognized so as to counterbalance the introduction of the poison pill system, and that the necessary institutional infrastructure will develop as a result. In fact, shareholders of Tokyo Electron Ltd., Yokogawa Electric Corp., and Fanuc Ltd. rejected a proposal seeking an increase in authorized capital stock (an increase in the maximum number of shares that can be issued by board decision) in their respective general shareholders' meetings in June 2005. Meanwhile, all eight companies that proposed the introduction of a poison pill managed to obtain shareholder approval, but some influential institutional investors seem to have cast opposing votes. In this sense, Japanese corporate governance is standing at a crossroads.

References:
Berkowitz, D. and K. Pistor and J-F. Richard (2003), "Economic Development, legality and the transplant effect," European Economic Review 47: 165-195.
Comment, R. and G. Schwert (1995), "Poison or placebo? Evidence on the deterrence and wealth effects of modern antitakeover measures," Journal of Financial Economics 39: 3-43.
Gilson, R. (2004), "The poison pill in Japan: The missing infrastructure," Columbia Business Law Review: 33-40.

>> Original text in Japanese

* Translated by RIETI.

September 2005 Keizai Seminar (Economic Seminar)

September 16, 2005