https://www.wsj.com/articles/SB994204806867350184

July 4, 2001 12:01 am ET

By Nicholas Benes, president of JTP Corporation, an investment bank specializing in merger and acquisition advisory services in Japan

Japan plans to establish a “stock-buying fund,” supported by government guarantees and tax advantages. The objective is to soak up the supply overhang that will occur when banks sell stocks worth Y14 trillion through 2004 to comply with new rules that limit their stockholdings to total bank capital.

Rules legislating the reduction of bank shareholdings mark an important and long-overdue step toward better-functioning capital markets in Japan. But the government’s Financial Services Agency is touting a blueprint for the “stock-buying company” that will distort market mechanisms and prolong the inefficiencies and poor corporate governance of the county’s labyrinthine cross-shareholding system. And it will probably not soak up much supply of stock or help the market recover.

The FSA’s plan has the following key features:

• The fund is set up as a private corporation and is not subject to any proposed requirements regarding disclosure, reporting, fiduciary duty, accountability or independent monitoring other than what is in the Commercial Code. There appear to be no standards for these matters except those the controlling banks see fit to provide. To the rest of the world — including taxpayers — governance is a black box.
• No persons or groups have yet been specified as the investment manager(s), who will be held accountable for the selldown process, and there is no fair and objective process for selecting such manager(s). In fact, it seems managers won’t be appointed at all, since it appears bank executives will be seconded.
• There is no clear criteria that the investment manager(s) must apply in making divestment decisions.
• The stock-buying corporation has no duty to exercise corporate governance rights (e.g., voting by proxy) for stocks that it holds. It’s likely that corporate governance rights either will not be exercised — reducing the efficiency of the capital markets — or will be retained by the banks (who do not exercise them much either).
• There’s no clear plan or process for the “exit strategy” of selling down stocks and portfolios that the fund acquires. Rather, there is only a rough concept and a menu of wishful possibilities: “The fund will design exchange-traded funds … create mutual funds … sell into stock buybacks … sell in the future” and so on.
• Moreover, for long-term holdings, the fund is designed so that each bank can retain control over future sales by the fund of the shares which that bank originally sold to the fund. This intended outcome is clearly signaled by the scheme’s features. The banks will second their own executives to the fund, rather than hiring outside fund managers. Each bank provides the loans that finance the fund’s purchases from itself, and therefore retains special rights as the lender to its own “separate account.” There is no real incentive for the fund company to maximize returns for the “general account” of all shareholding participants. There is no disclosure of inner workings and decisions.

This retention of control threatens to decapitate the premium prices that strategic investors would pay for certain stocks, especially if pooling was used to create larger positions. In order to “defend” those companies from takeover threats or unwanted shareholders, many banks will probably retain rights to direct who the buyer should be, or to repurchase the stocks themselves. For strategic or active investors, there will be no point in bidding at all, let alone at a premium price.

With the FSA’s kind of “stock-buying company” everybody loses. The key questions to ask with respect to a collective “fund” are obvious. What is the value creation thesis? Will a transparent and fair bidding process that maximizes value be required or not? In this case, the answers are “none” and “no,” respectively. Under this plan, the banks will have received less value than if the fund had prohibited the retention of sales control rights. The government is effectively encouraging and allowing the banks to do this, against the interests of bank shareholders.

Overall corporate governance, therefore, will remain poor and the market will not have found the most capable and supportive shareholders to grow companies so that they can hire more employees. The risk is increased that government will pay out on the guarantees; if so, taxpayers will eventually have to foot the bill and Japan’s economic and fiscal crises is likely to worsen.

In order to improve capital markets, raise corporate profitability, and create more jobs and economic growth, any “collective fund” plan should have the following key features:

• Stringent requirements of public disclosure, reporting, fiduciary duty requirements, accountability and independent monitoring.
• Clear, fair and objective processes for selecting the investment manager(s), which should be outside parties subject to reporting requirements and incentives to maximize value and other goals.
• Detailed selection criteria for these investment manager(s), on a well-defined value-creation thesis and the selldown process.
• Exact criteria for the manager(s) to apply in making divestment decisions. Value maximization would be the highest priority. To evaluate non-price criteria, the fund’s board should require outside opinions about fairness and the disclosure of all internal analysis justifying its decisions.
• A detailed plan and process for the “exit strategy” of selling down stocks and portfolios that the fund acquires, including the pooling of stocks into larger positions for sale to strategic acquirers or active “relational” investors.
• The fund managers must exercise corporate governance rights (e.g., voting by proxy) solely in the interests of the fund as defined by its investment criteria and standards, and must document their actions.
• Participating banks should be prohibited from retaining sales control rights, buyback options, or governance rights with respect to stocks that they sell to the fund.
• Only if all these conditions are met should the government extend guarantees to the fund, and/or tax advantages to the participating banks.

For many stocks, the FSA’s planned configuration of the stock-buying fund will only delay the fix that is so urgently needed: the movement of shares to holders who bid the most. It will merely sweep shares from one rotten pile, exercising no shareholder voice or fiduciary duty, into another much larger one — with cost and risk borne disproportionately by taxpayers.

Neither will it maximize value, because its whole purpose is to preserve the cozy status quo as long as possible by avoiding the types of sales that would most increase market prices: sales to strategic or active investors. For the same reason, it may not unwind Japan’s cross-shareholdings at all, but rather stretch out the market “overhang” of potential sales for most of the fund’s 10-year selldown period.

— From The Asian Wall Street Journal