Corporate governance is a relatively recent imported concept in Japan, and a concern for foreigners - particularly from the US and UK - not the Japanese. But corporate governance in Japan is actually healthier than in many other developed jurisdictions. The issues of dilution and independent directors have become issues for foreign investors weighing up Japan. According to the Tokyo Stock Exchange's [TSE] share ownership survey of 2008, the market value of shares held by foreigners in Japan dropped by 4% and the number held fell by 3.4% (compared to 2007); by comparison, the next largest fall in the number of shares held was 0.5% by securities companies from 13 categories of investor devised by the TSE. Two legal issues in particular are a problem - the equal treatment of shareholders required under Japanese law, and pricing.

Note: Changes to Tokyo Stock Exchange rules on private placements could pave the way for rights issues, foreign takeovers and independent directors

Rachel Evans

Asia editor

You won't find the phrase corporate governance in a dictionary of essential business Japanese. The translation of corporate governance is corporate governance. There is no widely recognised Kanji phrase. As this might suggest, corporate governance is a relatively recent imported concept, and a concern for foreigners -- particularly from the US and UK -- not the Japanese.

"Japanese company law is stronger in providing for shareholder rights than the US, on average"

Nicholas Benes, JTP Corporation

But corporate governance in Japan is actually healthier than in many other developed jurisdictions. As Nicholas Benes, president of boutique investment bank JTP Corporation, argues: "Japanese company law is already pretty strong in providing for shareholder rights; on average, it's stronger than in the US, especially regarding say-on-pay and access-to-the-proxy."

Unlike the US, for example, where shareholders face an expensive and uncertain battle should they wish to get their nomination for a director into the proxy materials, Japanese shareholders that have held a stake of 1% (or more than 300 voting units) for six months are entitled to have their nominee mentioned in the proxy materials. And while Japanese shareholders vote to approve or deny increases in executive pay, US shareholders can only pass non-binding resolutions that the board is not obliged to implement.

Japan has instead fallen down elsewhere. Shareholdings can be diluted through massive secondary offerings (Sumitomo raised yen863 billion ($9.2 billion) in equity from a public offering in June and yen57.6 billion from a third-party allotment in July) and companies are not required to have independent directors. In contrast, the US requires shareholder approval for secondary offerings over 20% of the existing shares and has several requirements regarding the number of independent directors that each company must have.

So the issues of dilution and independent directors have become issues for foreign investors weighing up Japan. According to the Tokyo Stock Exchange's [TSE] share ownership survey of 2008, the market value of shares held by foreigners in Japan dropped by 4% and the number held fell by 3.4% (compared to 2007); by comparison, the next largest fall in the number of shares held was 0.5% by securities companies from 13 categories of investor devised by the TSE. (See graph one.) Undoubtedly, some of this retreat can be attributed to the global downturn, but Japan is now keen to lure foreign investors back. To do so, it is addressing shareholder dilution through private placements to third parties -- third-party allotments -- by making shareholder approval mandatory for issues above a certain percentage. They are also trying to promote independent directors. Graph one: Foreign holdings as percent of market value

Source: 2008 Shareownership Survey, Tokyo Stock Exchange

The former will have a particularly big effect on international transactions. First, once third-party allotments require shareholder approval, their appeal as a means of financing will diminish. This could open the way for new methods -- including rights issues, which have so far not been popular in Japan thanks to the ease of private placements and local law issues. How to do a rights issue in Japan

Rights issues have been the talk of Tokyo for the past few months. With markets down at the beginning of the year and only the largest and most prestigious companies able to do public offerings or private placements, rights issues looked like they might provide an alternative. The TSE's decision to require shareholder approval for third-party allotments that dilute existing shares by 25% or more makes rights issues an appealing alternative.

But there haven't been any yet. Two legal issues in particular are a problem -- the equal treatment of shareholders required under Japanese law, and pricing. Shareholders cannot be excluded from an offering and prices cannot be "especially beneficial" to any group. As a result, companies with shareholders in the US or Europe would have to offer to these shareholders in a rights issue. In the US, this could require registration under the 1933 Securities Act and in Europe, this could require a prospectus. One solution would be to acquire an exemption -- but these can be hard to obtain -- another might be to require foreign shareholders to accept cash compensation instead of the subscription rights, or to sell the rights.

While some lawyers, such as Katsumasa Suzuki at Mori Hamada & Matsumoto, are optimistic that the market will see "one or two transactions, though they may be small" before the end of the year, others are tempering their initial enthusiasm. David Sneider at Simpson & Thacher says: "There were rumours of rights issues when companies needed to raise funds at the beginning of this year but my impression is that, although people are looking at them as a structural alternative, they're still a long way off." Tony Grundy at Morrison & Foerster adds: "The difficulty is not so much legal as finding an issuer willing to be the first to market. If we don't see one soon, a rights issue might not happen until the next downturn."

Second, in the past, third-party allotments have been used as a defence mechanism against hostile controlling shareholders. Such tactics are deemed legal, provided a legitimate fund-raising need is at the heart of the offering. Once the TSE introduces rules that require shareholder consent for any large third-party allotment, such defensive measures would have to be approved. This could open up Japanese companies to takeovers by domestic or foreign competitors.

Third, by signalling that the exchange is prepared to address corporate governance by requiring shareholder approval of third-party allotments, the TSE will open the way for further requirements. The exchange is debating a disclosure requirement suggested by the Ministry of Economy, Trade and Industry (Meti) under which each listed company would have to disclose information about its oversight, or lack of it, by independent directors. While this may take a while to come into effect -- particularly with a general election at the end of August -- such a rule would make information on independent directors available to Japanese and foreign investors. And with companies keen for new investment, this enforced disclosure could encourage companies to increase the number of independent directors to attract investors. "While foreign investment is here, corporate governance issues become of much more concern as corporate Japan needs to tap foreign sources of capital," says Paul McNicholl, a partner in the Tokyo office of Linklaters.

A big step for Japan

The Exchange's reforms to its listing rules were announced in May 2009, following a report published the previous month by the Advisory Group on Improvements to the TSE Listing System for the Tokyo Stock Exchange.

In the report (entitled For creating a better market environment in which investors feel secure), the advisory group outlined plans to require companies undertaking private placements that would dilute the existing shares by 25% or more, or those that result in a change of controlling shareholder, to obtain shareholder approval or a fairness opinion. These changes are supposed to come into effect in August but, at the time of going to press, had yet to be promulgated. Once they are (assuming politics -- national or internal -- or the economy does not derail these plans), shareholder consent should become an embedded concept in Japanese management culture.

The alternative to shareholder consent, a fairness opinion (assessing whether the issuance was required and the price was fair), would be needed from an independent party. Who those parties would be remains unclear and any pay-to-review model would have an inherent conflict of interest. However, it has been suggested that investment banks could extend their business to this area. In addition, the exchange plans to de-list companies that issue more than 300% of their outstanding share capital.

The limit on third-party allotments would mean that Japan joins many other jurisdictions that require shareholder approval. At the moment, companies just have to ensure that the price is at least 90% of the share price at the time of issuance. Japanese companies maintain four times their issued stock as authorised share capital, providing a lot of headroom for large secondary offerings at short notice. In contrast, UK companies' authorised share capital is more constrained, forcing them to do last minute increases -- which require shareholder approval -- if they wish to do large secondary issuances. And despite debate about increasing the quota, shareholder consent is mandatory for issuances above 5%. The US and Hong Kong are more relaxed, but both are still more stringent than Japan, requiring shareholder consent for offers above 20%.

However the 25% rule, despite being weaker than its contemporaries, is still a major step forward for shareholder rights in Japan. Since the 1966 Corporate Law, Articles 201.1 and 199.1-2 have allowed companies to issue private placements without consulting shareholders. Before that companies did have to get shareholder approval, but this provision was removed to counter the perceived threat from foreign, hostile takeovers. Foreign investment now seems quite attractive.

"There will be one or two rights issues this year, though they may be small"

Katsumasa Suzuki, Mori Hamada & Matsumoto

But while the rules will give control of private placements to shareholders -- or at least independent evaluators -- they could make cash raising harder. "It may be good for shareholders or an independent third party to be asked about third-party allotments," says Katsumasa Suzuki, a capital markets specialist at Mori Hamada & Matsumoto, "but these deals are done when a company really needs financing. It may be its only means of avoiding bankruptcy." The additional time taken to obtain shareholder approval or the additional cost required for an independent fairness opinion could push a company that is desperate for funds over the edge.

The first rights issues

The shake-up to third-party allotments should encourage companies to consider the most appropriate funding for their situation though. And so the best way to preserve shareholder value.

Rights issues may be an alternative that companies start to consider. In the past, companies were put off by having to negotiate matters such as pre-emption rights. As Andrew Carmichael at Linklaters in Tokyo says: "In the Japanese context, why go through the palaver of rights issues that they have in the EU when, in Japan, you do not have to?"

There are however several hurdles that rights issues still need to overcome. Japanese law requires that all shareholders be treated equally. This means that a rights issue could not exclude certain problematic shareholders -- such as those in the US -- that could create localised law problems. The US is a particular problem as it asks for all securities sold into the jurisdiction to be registered; it is often a costly, lengthy and legally difficult task to ensure that disclosure is up to standard. Japanese law also forbids securities from being offered at an especially beneficial price; this could limit the discount a company could offer in a rights issue. (See box on previous page.)

Defending the company

And third-party allotments may appeal more than rights issues because they can be used to defend against hostile takeovers or assertive controlling shareholders.

For example, in 2004, Bellsystem24 switched its controlling shareholder (CSK) by issuing shares to a friendlier sponsor (Nikko Cordial). CSK had opposed Bellsystem24's attempt to acquire a call-centre firm so Bellsystem24 did a third-party allotment to raise funds for the acquisition and simultaneously gained a new controlling shareholder.

Japan's corporate culture is traditionally one of mutual assistance. Historically, large group companies such as Mitsubishi or Mitsui have encouraged cross-shareholding among their subsidiaries. Suppliers and customers also purchase a stake as they have a common interest in the companies' success. However, rather than foster a system of accountability and democracy, cross-shareholding has created a large passive shareholder base that leaves power in the hands of the board.

"One of the greatest frauds perpetrated on Japanese shareholders is the influence and impact of cross-shareholdings, and a historic approach to who your shareholders should be," says one private practice lawyer. "By maintaining a shareholder base of customers and suppliers, you always have a chunk of very friendly supporters."

These friendly shareholders have not only slowed reforms to corporate governance, they have also restricted unwanted influences by taking third-party allotments. These private placements have allowed companies to reduce the stake of controlling or activist shareholders to diminish their influence or prevent a takeover. If such allotments now have to be approved at a shareholder meeting, they may not provide such an easy defence mechanism.

But defences have been losing popularity recently. "The market is strongly against more poison pills," says Benes at JTP Corporation. "They are not perceived to add value." Companies need to attract new investors rather than discourage them, and defence mechanisms don't maximise return or dividends. That said, the Asian Corporate Governance Association predicted in its May 2008 white paper on Japanese corporate governance that the number of companies with poison pills would rise from 266 to around 400 by the end of 2008.

The new restrictions on private placements will not necessarily spell the end for this type of defence mechanism. If shareholders vote to approve the allotment, previous court cases suggest that, provided there is a pretext for raising funds, the right of companies to take such action is strengthened. For example, Japan's Supreme Court upheld Bulldog Sauce's defence against a hostile takeover by Steel Partners because it was sanctioned by a shareholder meeting. It was not a third-party allotment (it involved the issuance of stock acquisition rights to dilute Steel Partners' stake) but the Court's ruling on the basis of shareholder approval suggests that this would be a factor if a third-party allotment was used in the future.

Perfecting corporate governance

"Boards should realise that shareholders are owners of the business, not just the stewards"

Paul McNicholl, Linklaters

But the biggest winner from all this will probably be corporate governance. By requiring more discussion of fund raising and M&A defence with shareholders, boards should come to "a greater realisation that shareholders are owners of the business, not just the stewards" as McNicholl at Linklaters puts it. This, in turn, should bring foreign investment back to Japan.

Japan's relationship with shareholders has not been an easy one. Shareholder meetings used to be disrupted by "quasi gangsters [sokaiya] aiming to squeeze hush money out of companies," says Kenneth Lebrun of Shearman & Sterling's Tokyo office. Sokaiya were originally hired by companies to shout-down opposition at shareholder meetings, but blackmail against these companies proved to be more lucrative. From the mid-sixties, sokaiya would regularly hijack shareholder meetings until silenced by bribes. Juntaro Suzuki, the vice president of Fujifilm, was even murdered in 1994 by a suspected sokaiya when he allegedly refused to pay such bribes.

In response, all companies started to hold their shareholder meetings on the same day -- the last Thursday in June. According to studies by the Asian Corporate Governance Association, 960 to 1000 companies hold their meetings on this day (out of approximately 1800 listed), with a further 220 to 260 on the last Wednesday and 160 to 175 on the last Tuesday. Most Japanese companies have a March 31 year-end and are required by Japanese law to have their annual general meeting within 90 days.

Even companies that do not have their meetings in the final week tend to clump their meetings together in a bid to avoid sokaiya. They also try to keep meetings as short as possible -- to around 30 minutes. So it is understandable that companies are suspicious of shareholders and any forum that gives them a say.

Coupled with this, the threat to Japanese companies after the war from foreign takeovers encouraged these corporations to turn inwards. Meti promoted cross-shareholdings between friendly companies and the practice of maintaining independent directors that had existed before the war ended. Boards typically comprise former employees of the company. Employees do not move between companies in the way that professionals typically do in Europe or the US; instead, "being a director is the final career goal of a newly graduated employee," says Nobuo Nakata at Allen & Overy, "and this means directors often think as an employee rather than about what is best for the shareholders."

In almost all Japanese companies, shareholders must rely on statutory auditors to hold the board accountable. Statutory auditors cannot be employees of the company they audit, cannot vote on the board and they report their findings to shareholders and the AGM. The system's supporters argue that statutory auditors are therefore by their nature independent because they do not work for the company and are not on the board. However, they can work for a parent or subsidiary. As Benes colourfully illustrates: "This is the same logic as saying that directors' husbands, mistresses, uncles, wives, or golf buddies are independent, just because they don't vote on the board." And statutory auditors do not have the power to force management changes.

This model of statutory auditors is at odds with the independent director system in other countries, such as the US. There the system of independent directors grew up after the war as shareholders pushed for greater transparency and accountability. Some boards are now primarily comprised of independent directors, and legislation -- such as Sarbanes-Oxley -- has reinforced their role in key areas such as the audit committee. In an attempt to promote a corporate governance regime that reassures foreign investors, the Japanese government established the so-called independent committee system as an alternative means of corporate governance. Under that system, three separate committees (audit, nomination and compensation) monitor the company. More than 50% of each committee must be comprised of outside directors, while at least one member per committee should be an independent director.

However, statistics from the Keidanren, Japan's business pressure group, show that 97.3% of listed companies still maintain a statutory auditor model of corporate governance. Some have added outside directors (44.1% according to the TSE's 2009 white paper on corporate governance) but few have elected more than one. Japanese companies are still disinclined to adopt the new, international-investor-friendly model.

One reason is a perceived lack of suitable candidates. Because of historical cross-shareholding and because employees typically remain with a company for life, there are few available. "It's very difficult to define independence as there's such a high level of connections between businesses," says McNicholl at Linklaters.

But independent and outside directors are clearly a concern for foreign investors. The TSE's 2009 white paper shows that foreign investors buy larger stakes in companies that are governed under the committee system: while 32.7% of foreign investors in committee-type companies bought 30% or more of the shares, only 8.4 % of foreign investors bought more than 30% of a company with a statutory auditor system (see graph two). Meti is therefore keen to encourage companies to appoint more external directors. In its corporate governance study in June, it failed to make independent directors a requirement, but it did suggest a disclosure system to cover directors and their status. The TSE is likely to implement this, but discussion continues between the exchange and Meti about the format. Graph two: Foreign shareholders by corporate governance model

Source: TSE-Listed Companies White Paper on Corporate Governance 2009, Tokyo Stock Exchange

A comply-or-explain requirement would improve transparency and help shareholders pick suitable companies in which to invest. But the government and the exchange could face further obstacles; opposition by the Keidanren earlier in the year forced Meti to take a proposal for mandatory independent directors off the table.

At the moment though, the need to attract foreign investors is pushing forward this proposal, as well as the requirement for shareholder approval of third-party allotments. Reform is needed while the momentum remains.