https://www.wsj.com/articles/SB90701616960233500　

By Nicholas Benes　　

Sept. 29, 1998 12:01 am ET

Japan’s economy is now at a crossroads; it not only needs more financial fuel, but it also needs an overhaul of its “engine” of corporate governance, finance and growth. Without this, Japan will not be able to revive its economy or overcome future fiscal problems. Chronic misallocation of capital will sink still deeper roots, and rates of return will decline further. To prevent this from happening, rapid expansion of open mergers and acquisitions and restructuring activity is urgently needed.

Japanese legislators can no longer afford to draft their “bank cleanup” policies or “stimulus packages” based mainly on satisfying special interests or their desire to avoid disclosure of past mistakes and scandals. Rather, they must focus their efforts on reconfiguring a few key drivers of efficient capital allocation: disclosure, corporate governance, accountability, price and free transfers. This would facilitate much-needed mergers and acquisitions, thus accelerating the pace of restructuring and asset redeployment. Sadly, Japan’s leaders have hardly begun this process and are in danger of taking a step backwards.

The slow death of the Long-Term Credit Bank of Japan is a prime example of how Japan’s politicians have a penchant for putting political concerns ahead of economic viability. LTCB is failing due to huge misallocations of capital and irresponsible lending sprees undertaken over more than a decade. For months, the ruling Liberal Democratic Party had pinned its hopes on lax and massive injections of public money for political reasons, none of which have much to do with actually fixing the system that created this disaster. But as of last weekend, it now appears as if the opposition has finally forced the LDP into a compromise clearing the way for the government to nationalize the struggling lender and liquidate its assets.

A quick injection of capital into LTCB would have allowed the bank’s managers to unilaterally forgive some $3 billion of loans to Japan Leasing Corp., which filed for bankruptcy Sunday evening after it became apparent that the loans would not be forgiven. The LDP had long argued that the forgiveness of loans to Japan Leasing and several other LTCB affiliates was needed to avoid a disastrous worsening of the ongoing “credit crunch.”

But the LDP’s unspoken reasons for wanting to quickly pump taxpayers’ money into LTCB were far more self serving. If Japan Leasing is indeed liquidated in bankruptcy court it will be forced to default on, or restructure, its own huge borrowings from a large number of agricultural cooperatives and credit associations in rural areas, most of which are not covered by deposit insurance. The deposit-holders of these rural banks are the prime voting base of the LDP. From this, large-scale personal bankruptcies may ensue. But will this in fact cause a massive worsening of the credit crunch? Not likely. It may, however, cause the LDP to lose the next election.

The LDP also decries the dangers of a growing credit crunch to protect its other mainstay constituency, the construction industry. Many large construction companies are big borrowers from LTCB. Supplied with LDP-sponsored public-works spending for years, the industry has colossal over-capacity and will have to shrink no matter what happens to LTCB. Many construction companies are quintessential “deadbeat” borrowers kept on life-support only because of the continued willingness of banks to roll over loans rather than write them off. Often, such loans are used to cover losses or support real-estate holdings that are kept off the market, which in turn deprives the economy of the liquidity and transactions flow that help set prices.

Beyond superficial rhetoric about the “credit crunch,” is it good for the Japanese economy that capital is increasingly tied up in loans to Japan Leasing or construction companies, bloating over time? Clearly not. Rather, this is a huge efficiency drag which reduces investment returns and is substantially slowing down recovery and the redeployment of capital that might create loan growth and economic expansion. Capital is not available to the borrowers who deserve it based on their actual profitability and growth prospects. Thus, continuing to prop up deadbeat borrowers prolongs the credit crunch in the name of preventing it.

In this sense, the “principles-first” approach of Naoto Kan and other opposition leaders is refreshing, and indeed the only tactic that will prevent the banking crisis from worsening. Corporate governance and competitive bidding in M&A transactions is a necessity in modern Japan. But note that nowhere in the debate over the proposed merger between LTCB and Sumitomo Trust did the matter of price come up. Is this not very odd? This makes absolutely no sense in any world except a smoke-filled den of predesignated merger partners.

Even before last weekend’s agreement to nationalize LTCB, the government should have compelled the bank to put itself (or its assets) on the market in an open competitive auction as a condition to receiving public funds. Only this approach can maximize the price and discipline the process. If distressed assets are removed from its books under government supervision, LTCB may have greater positive value to an acquirer which does not duplicate its functions as much as Sumitomo Trust.

In short, principles matter, as does the infrastructure for corporate finance and corporate governance. Accordingly, the Japanese government should immediately implement the following measures to promote the growth of M&A activity and restructurings:

• Phase in a requirement that all exchange-listed companies in Japan must have a majority of “outside” board members; e.g., directors who do not have an employment relationship with that company. The fair and simple message would be, “If you want to use the public capital markets, you are required to have an open and healthy corporate governance process.”
• Change the securities regulations so as to permit acquirers to pay a “control premium” by offering a separate price for large blocks of shares if the buyer is able to acquire aggregate holdings past a certain level; e.g., 50%. (At present, it is not possible to offer a premium price for large trades that help in obtaining control.)
• Permit consolidated tax reporting so that acquiring companies can benefit from the “tax shield” of accumulated losses of companies they buy where there is not a full merger.
• Create a section of the tax code that allows tax-free treatment in all “stock swap” or pooling transactions where the seller has not received any cash consideration.
• Equalize tax treatment between capital gains taxes in the case of the sale of stock by the owner of an unlisted company (presently 26% of the gain), and capital gains taxes in the case of sales of listed shares (presently only 1% of gross sales proceeds).
• Set up a framework in Japanese administrative law so that private companies can seek and obtain “no-action” letters from public and quasi-public regulatory bodies, so that they can know in advance the legal permissibility of transactions or structures. (At present, inquiries to agencies do not result in clear guidance as to the legality or prospective regulatory treatment of planned transactions, creating transactions risk for investors or acquirers.)

Of all these measures, by far the most effective would be requiring outside board members on publicly listed companies. This would have the largest immediate impact and, in fact, a larger impact than all other regulatory changes that can realistically be imagined. At present, Japanese boards of most listed companies do not function so as to maximize shareholder value by giving serious consideration to acquisition proposals. Outside directors will increase the observance of fiduciary duties in this regard, while decreasing the inherent bias of employee-directors which now comprise nearly 100% of the boards of Japanese public companies.

Improved corporate governance is the key to an immediate and sustained recovery in Japan. Without these improvements, the gross misallocation of funds will persist and the economy will continue to founder.

Mr. Benes is president of Japan Transaction Partners, an investment bank specializing in M&A advisory services in the Japanese market.

–From The Asian Wall Street Journal