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A 19bn yen takeover exposes holes in shareholder protection

Real corporate governance reform in Japan will require more than tweaking a few rules

| Japan

The 19 billion yen ($166 million) partial takeover completed last month in the Japanese chemical industry of Nihon Nohyaku by Adeka would once have been a quiet back page item in the financial press.

But at a time when Japan is trying to raise corporate governance standards to global norms, the transaction has raised eyebrows because it reveals multiple ways in which Japanese corporate law and enforcement still fall short.

Quite simply, the Adeka deal would not fly in jurisdictions such as the U.S. and U.K., in which protecting the interests of minority shareholders against a large corporate shareholder like Adeka is taken for granted as a basic principle of good corporate governance.

General shareholders of Nihon Nohyaku, a leading agricultural chemicals maker, have objected to the perfectly legal, but coercive and unfair, two-step technique that Adeka, a specialty chemicals group, used to acquire a 51% controlling interest at a bargain price.

But they should be just as upset with the uniquely Japanese phenomenon the transaction creates -- a so-called "listed subsidiary" controlled by Adeka that leaves general shareholders as an impotent minority, at the mercy of decisions made by Adeka-appointed management.

"Listed subsidiaries" -- public companies majority-owned by other public companies -- constitute 10% of listed Japanese companies but are virtually unknown in the U.S. and much of Europe. The best-known example is NTT Docomo, the mobile telecoms company, which is 63%-owned by Nippon Telegraph and Telephone.

Listed subsidiaries are rare outside Japan because the inherent conflicts of interest are vulnerable to legal attack. In the U.S., legal protections for general shareholders would subject the management of both the controlling parent and subsidiary companies to scrutiny that would work to prevent the parent from treating the subsidiary as its own errand boy. A listed subsidiary in the U.S. would not only be awkward to manage, it would be a ripe target for litigation.

By contrast, in Japan, the prevailing rules allow listed subsidiaries to be operated as obedient servant companies for the benefit of their masters, without meaningful protections for minority shareholders of the servant company.

The absence of an effective requirement that boards of Japanese public companies be independent makes it easy for management of the master and servant companies to enter into cozy arrangements that are disadvantageous to the servant's minority shareholders. Compounding matters, Japanese courts have not been receptive to lawsuits brought by shareholders of listed subsidiaries challenging the disadvantageous terms of transactions with the parent entity.

In recent years the Tokyo Stock Exchange and regulators have begun to encourage eliminating listed subsidiaries, citing concern about the inherent conflicts of interest.

In response, there has been an uptick in Japanese parent companies buying out general shareholders and acquiring 100% of their listed subsidiaries. There is now a consensus within the Japanese establishment that listed subsidiaries go against the objective of raising governance standards.

In the light of this growing concern, one can only scratch one's head at why the Adeka and Nihon Nohyaku managements have created yet another listed subsidiary. Put another way, why didn't Adeka seek to acquire 100% instead of just 51%? The obvious answer is not reassuring to Nihon Nohyaku's general shareholders: Acquiring 100% would be too expensive and force Adeka to spend more than it wanted. Why should Adeka pay for 100% when acquiring 51% gives Adeka all the benefits of control -- at half the price!

Beyond this unfortunate result, the technique Adeka used, within Japan's existing legal framework, to increase its ownership of Nihon Nohyaku from 23% to 51% at a bargain price, while leaving general shareholders as unwilling minority shareholders of a devalued servant company, could never have succeeded in the U.S. or Europe. The approach would have fallen foul of laws that protect minority shareholders.

Adeka's acquisition of additional shares to take it to 51% ownership at a low price employed a clever two-step technique devised by Japanese law firms several years ago. The first step was a tender offer In September 2018 in which Adeka offered to buy from other Nihon Nohyaku shareholders a limited portion of the additional shares it needed to acquire 51% ownership, at a premium over the most recent market price. Adeka offered to buy up to 18% of the outstanding Nihon Nohyaku shares from general shareholders for 900 yen a share, a 34% premium over the most recent market price of 670 yen a share.

The immediately following second step was a third-party allotment, in which Adeka purchased newly issued shares from Nihon Nohyaku itself, not for the 900 yen/ share tender offer price, but for the 670 yen/share price that prevailed prior to announcement of the transaction. The result is that, by combining the two transactions, Adeka was able to acquire control for an average price that was much less than what it would have paid if it had acquired all the shares by a tender offer.

Put yourself in the shoes of the general shareholders of Nihon Nohyaku and you will understand why they are upset. The opportunity to sell your shares at 900 yen/share is attractive compared with the most recent market price of 670 yen/share, especially when you consider that, following the transaction, your company will have become a "servant" company of Adeka. You would like to exit and sell out at 900 yen/share. But wait. The 900 yen/share tender offer price applies to at most 18% of the shares. That means that if all other general shareholders also decide, like you, to sell, you will be able to sell only a portion of your shares and you will be forced, against your will, to remain as a minority shareholder of a servant company very different from the company in which you originally invested.

The natural reaction of foreign fund managers to this result is stunned disbelief -- this could never happen outside Japan. But the reality is that this is perfectly legal in Japan and that no court would stop it. It is not just an inadvertent legal loophole. Rather, the prevailing rules systemically fail to provide minority shareholders with protections they enjoy in many other developed countries, to the benefit of large corporate shareholders like Adeka.

Nihon Nohyaku has told the media that it had received "opinions from shareholders" and would " hold sincere dialogue" with them. But the deal has been completed anyway.

Japan has pledged to raise its corporate governance to global standards. Yet, as the Adeka case illustrates, it struggles to achieve that aim because the law favors large corporate shareholders. Webs of corporations owning other corporations -- employees making shareholder decisions -- creates a cozy system in which managers can exchange favors and avoid accountability. Not surprisingly, many managers like the system just as it is. Improving corporate governance in Japan will require more than the current toothless corporate governance code or tweaking a few rules.

.Stephen Givens is a practising corporate lawyer based in Tokyo.  He has advised Usonian Investments LLC regarding the transactions described in this article

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