Risk & Governance Weekly

Global Roundup

By Marc Goldstein, Director of International Research, Japan

This article is condensed from an M&A Edge Note released on July 10 by RiskMetrics Group’s M&A Edge team.

For the second straight year, shareholder activism generated headlines in the run-up to the Japanese proxy season. But once again, the activists achieved only limited success, as target companies fought back with every weapon in their arsenal.

Perhaps the most notable weapon in managements’ arsenals is the all-out effort to attract management-friendly shareholders from among the ranks of companies’ lenders and business partners. Cross-shareholding rates rose in 2007-08, the second consecutive increase after 15 straight years of decline, and news reports indicate that the increase is continuing in 2008-09.

By committing to hold shares indefinitely, and vote them with management in all situations, corporate shareholders are denying themselves both a voice and an exit. Data from the Nikkei newspaper indicates that the unrealized gains on shares held by Japan’s listed companies plunged 47 percent in the 2007-08 fiscal year. At some of the more enthusiastic practitioners of cross-shareholding, such as Nippon Steel and Toyota Industries, the drop in latent profits amounted to several hundred billion yen. Yet because companies do not need the permission of their own shareholders to buy shares in a business partner--or even a competitor--in most cases ordinary investors have no opportunity to weigh in.

Electric Power Development (J-Power) was a rare exception to this general rule, because The Children’s Investment Fund (TCI), which owns a 9.9 percent stake, submitted a shareholder proposal calling for an article amendment to limit the value of J-Power’s holdings of shares in other companies. TCI also placed proposals on the agenda calling for a dividend increase, the establishment of a share repurchase framework, and another amendment mandating the appointment of outside directors.

Yet TCI’s proposal would have forced radical changes, which would not necessarily have benefited ordinary shareholders. TCI’s proposed article amendment would have required the company to reduce its corporate shareholdings, which TCI estimated at ¥68 billion ($648.7 million), to no more than ¥5 billion ($47.7 million), or 0.25 percent of total consolidated assets. Because J-Power’s holdings are concentrated in a relatively small number of companies, a rapid sale of that magnitude would have likely pushed down the share prices of the companies in question.

Another governance-related proposal from TCI would have required J-Power to appoint at least three outsiders to its board. J-Power argued that requiring outsiders to serve on the board, without regard to the abilities or experience of a particular candidate, would interfere with shareholders' right to choose directors from among the best-qualified candidates, and could hinder the functioning of the board.

Unless the company appoints outsiders to the board of directors, the creation of a board of executive officers means little, as one group of insiders is supervising another group of insider--and in Japan it is common for many directors to serve simultaneously as executive officers, in which case they are asked to supervise themselves.

TCI also presented two dividend proposals in 2008: one calling for a full-year dividend of ¥120 ($1.14) and one calling for a full-year payout of ¥80 ($0.76). However, in the end, TCI once again failed to convince a majority of shareholders to back its proposals. To some extent, this was clearly because cross-shareholders voted with J-Power management, as TCI has repeatedly pointed out. But TCI’s own actions may have alienated some of the Japanese retail and institutional investors who might otherwise have supported the fund. For instance, TCI’s criticism of the Ministry of Economy, Trade, and Industry over its decision to bar TCI from increasing its stake, appear to have won it few supporters.

Nihon Housing and Harakosan

An even starker case of conflict was that of condominium manager Nihon Housing (NH), which faced an unsolicited tender offer from condominium developer Harakosan. At the time the bid was announced in February, Harakosan’s cash offer of ¥1000 ($9.35) per share represented a 45 percent premium to NH’s share price; which had not exceeded ¥1000 since February 2006. But because NH had a poison pill in place, the offer was contingent upon a shareholder vote not to trigger the pill.

NH announced in May that it opposed the bid for two reasons: first, that Harakosan’s financial condition was not strong enough, and second, that its own business model is dependent on its remaining unaffiliated with any particular condominium developer so it can continue to win orders from developers who prefer not to do business with their own rivals.

Harakosan argued that a vote in favor of the poison pill, ending its bid for NH, would likely cause NH shares to fall back to their level prior to the offer announcement. In the end, a majority of NH shareholders sided with management, and voted to trigger the pill. Two director candidates nominated by Harakosan were defeated as well.

There was one important outcome of this case which could benefit shareholders in future acquisitions: the Tokyo High Court ruled that NH was required to turn over its shareholder register to Harakosan (which was already a registered shareholder), reversing a lower court ruling that NH could deny access because it viewed Harakosan as a competitor. Access to the shareholder register is critical to succeeding in a proxy contest in Japan. Although the High Court ruling, 15 days before NH’s meeting, may have come too late for Harakosan to use the information to mount an effective campaign for support, future strategic bidders now have a new tool to use.

Aderans: A Successful Activist Bid

The one successful case of shareholder activism during the 2008 proxy season came at wig and hairpiece maker Aderans Holdings on May 29. The company’s largest shareholder is the Japanese arm of U.S. investment fund Steel Partners, which owns 27 percent of Aderans’ shares. Having failed in its attempt last year to prevent Aderans from introducing a poison pill, and having seen the share price fall some 25 percent over the ensuing 12 months, Steel decided to oppose the reelection of all incumbent directors in 2008. Although Steel did not conduct a proxy contest, or mount a public relations campaign, it nevertheless won over enough other shareholders to deny the incumbents the majority they needed for reelection.

Steel may have succeeded precisely because it used a low-key approach and did not try to pressure other shareholders into choosing sides. Japanese corporate law requires companies to have at least three directors, and boards are not allowed to fill vacancies without a shareholder vote. As a result, Aderans’ incumbent directors will continue to serve until the company holds a special meeting on Aug. 9 to appoint their replacements. The new director line-up will include a majority of outsiders.

If the new board succeeds in creating sustainable value for shareholders, future activists will have a model to point to as they try to win support from mainstream investors to oust the directors of other underperforming companies. On the other hand, if Aderans’ share price stagnates, or declines further, many of those mainstream investors are likely to conclude that replacing the board may not work in Japan, where most directors are lifelong employees and lateral hiring remains rare.

Fresh off its victory at Aderans, Steel Partners has renewed its effort to increase its stake in brewing company Sapporo. Steel first offered to buy a 66.6 percent stake in Sapporo in February 2007, subject to management’s approval. Sapporo’s board expressed concern about the fate of minority shareholders who would remain invested after Steel took a controlling stake. In March, Steel responded by proposing to limit its stake to only 33.3 percent--all but eliminating the most important reason for Sapporo’s opposition. At the same time, Steel raised its offer price, stating that the higher bid price was justified by its favorable view of Sapporo's revised midterm management plan. On June 9, the company asked Steel to provide “assistance in improving corporate value, while maintaining a stake below 20 percent,” which Steel interpreted as a rejection of the revised offer.

In a July 8 letter, Steel blasting the board for its “unwillingness to engage in meaningful negotiations.” Although the timing may have been coincidental, the letter was sent three days after a news report predicted that Sapporo would be overtaken by rival beermaker Suntory in the first half of 2008, for the first time ever. This prediction was proven correct when sales figures were released on July 10.

“Mainstream” institutional shareholders have taken notice of the underperformance of Japanese companies. The Pension Fund Association, and investors including Nomura Asset Management, have indicated they will consider voting against directors of Japanese companies with sub-par returns on equity. There also is an increasing recognition among Japanese regulators that companies have gone too far, and are using defenses to block legitimate bids to the detriment of shareholders. Japan’s Ministry of Economy, Trade, and Industry, whose corporate value study committee effectively gave the green light to poison pills in 2005, has recently released a document criticizing issuers for excessive defenses.