https://www.wsj.com/articles/SB111411984180013724

By Nicholas Benes

April 22, 2005 12:01 am ET

Internet portal company Livedoor’s hostile attempt to take over Nippon Broadcasting and Fuji Television ultimately failed, with Livedoor’s shares in Nippon Broadcasting instead being bought by Fuji. Yet the collateral damage may end up being very large. Despite the bid failing in a market where almost none are ever made because the risks are so huge, this close call has unleashed a xenophobic fear of markets, suddenly threatening much of the progress Japan has made over the past decade. The first victim is Japan’s new draft Commercial Code, which is wending its way towards final revision in the Diet.

Panicked Japanese executives have created an opening for a small group of parliamentarians from the ruling Liberal Democratic Party to pile excessive “takeover defense” baggage onto the draft Commercial Code. Nonperforming managers may figure the additional safeguards will guarantee their jobs, but they are putting at risk the credibility of Japan’s stock markets and its commitment to market-based reforms.

Never mind that the proposed schemes for triangular mergers only facilitate friendly M&A transactions and corporate reorganizations, both domestic and cross-border. (With a triangular merger, an acquiring company can use its own stock, rather than cash, to buy a Japanese company.) Never mind also that such stock swaps, which only strategic investors (not funds) can propose, are the sort of value-added M&A deals that might revitalize many undervalued companies here. Amid the post-Livedoor panic frenzy these transactions are being lumped together with “hostile takeovers” as a convenient excuse to claim that an imaginary “wave of hostile M&A by big foreign companies” is about to hit Japan.

This trumped-up “crisis” supposedly justifies speeding through the Diet all manner of U.S. legal devices making it easier for managers to adopt takeover defenses such as poison pills, but without importing any of the governance rules that are the mainstay of that system, and which are essential to preventing managerial abuse.

To make things worse, the same knives now threaten to gut the triangular mergers provisions themselves. Though there is no rational connection to hostile deals, implementation of triangular mergers (including cross-border deals) has been delayed by a year “in order to give time for companies to install takeover defenses.” If an acquirer is not listed on a stock exchange in Japan — and very few are, since there is no equivalent of the American Depository Regime system — an extra requirement for approval by a very high percentage of shareholders has been proposed. And in the most recent version of panic-driven legislation, Japan’s insider-led boards may be given the discretion to unilaterally impose irrevocable “scorched earth” on deals: a three to five year freeze on all subsequent mergers and significant asset sales.

It would be one thing if Japan already had a hostile M&A market of any significance, and takeover defenses could be properly policed by corporate governance practices such as independent outside directors and CFOs with clear duties.

But alas, the necessary corporate governance infrastructure just isn’t in place. Anyone who knows what really goes on in Japanese M&A deals knows that the vast majority of Japanese boards (which are controlled by insiders) will simply view the newly enabled defense devices as opportunities to entrench themselves further in their corporate castles by “saying no” to whomever they like. After all, there is no offsetting pressure at present, and the new defensive tools do not come packaged with any additional legal changes to install governance practices that could serve as a brake, forcing the approval of deals that are beneficial for shareholders. Rather the opposite: boards may not even have the power (let alone the duty) to retract defenses in the face of an improved, attractive bid.

In unavoidable recognition of this, the LDP committee formed to consider the Commercial Code has given itself the Orwellian name, “Corporate Governance Committee.” But the guidelines for implementation proposed by the Ministry of the Economy, Trade and Industry (METI) are wide enough to drive a truck through, and lack legal force. And the LDP is not discussing what Japanese companies need most of all: laws requiring exchange-traded companies to have a majority of independent outside directors, and a beefed-up Securities and Exchange Surveillance Commission (SESC) that improves governance and mediates M&A-related disputes. Right now, the SESC does neither, and has a budget that is only 3-4% that of the SEC’s, holding steady. (Yes, you read right: that’s 3-4%.)

Japan’s strategy of “any and all defenses, but with no brakes” could easily backfire. With less market pressure to perform, managers will perform less well. And if they focus their time and energy on fortifying the castle walls, one can expect less actual business to get done inside. Since such circumstances are not normally good for stock prices, share prices for such companies may well decline, making them even more the targets of arbitrage investors, greenmail, or aggressive funds.

Bizarrely, despite their single-minded focus on finding new takeover defenses, the LDP parliamentarians have missed the obvious fact that triangular mergers themselves would be one of the best defenses to have available – and one of the only that could raise corporate value rather then eroding it. What better way to countervail against a hostile cash takeover bid, than by bringing on a friendly “white knight” by means of a stock swap or triangular merger? The “white knight” would not need to raise cash to make the acquisition; it could freely use its own stock, or other stockholdings. To make such defenses even more effective, the Ministry of Finance should extend tax deferral for sellers to “exchange offers.”

If they could roll over their prior tax basis to the newly-received shares without paying tax, more shareholders would sell into such “white knight” offers. At present, almost no one would sell, because they would then have to pay tax without having received any cash. Another benefit of deferral would be that such defensive transactions would not have to end with the delisting of the targeted company. Deals like this could rejuvenate much of corporate Japan, without thinning out the stock market.

The government’s one-year delay does not make any sense. Reality is the exact opposite of what is being assumed: in order to “protect” Japanese companies while increasing “corporate value” (METI’s favorite reason), the parliamentarians should want the immediate implementation of triangular mergers, not a one-year delay.

Most of the companies in Japan that are likely to be targeted by arbitrageurs and hostile parties, are trading at under book value for good reasons: poor profitability and poor strategy. The market is essentially saying, “positive change needs to take place, and faster.” The way to get these companies’ share prices trading above book value again is to encourage them to accelerate such change and add new synergies and partners, not to make it easier to “just say no” and stick with the status quo. If hostile bids could be a catalyst for this process and force consolidation via white knights, it would be very good for Japan. But recently, things are going in the opposite direction: there will be fewer hostile bids, and it will be harder to bring in a white knight.

Yet in the midst of all this confusion, there has been a sea change in public opinion. Some 70% of the public supported Livedoor’s (the hostile party’s) position, largely because every night on the evening news they could see the defects of insider-led corporate governance at Fuji Television, and they agreed that change was needed even if they did not like everything they saw over at Livedoor. With a little luck, perhaps some of this common sense will penetrate the Diet over the next few

Mr. Benes is president of JTP Corporation, an investment bank in Tokyo specializing in mergers and acquisitions.