Commercial Code Reform

Back to Contents of Issue: October 2001

How do recent and proposed changes in Japan's investment regulations affect investors in Japanese companies?

by Charles C. Comey and Scott A. Jalowayski

THE TALK OF THE town in Tokyo, as well as other financial centers around the world, has for several months revolved around the prospects for Japanese economic reform. The popularity of Prime Minister Junichiro Koizumi has heightened expectations that long overdue measures will be implemented. An important part of the ongoing debate concerning reform involves proposed amendments to Japan's Commercial Code and related changes to bolster investment and restructuring transactions.

In this article, we review several proposed amendments to the Code as set forth in the Ministry of Justice's Interim Report on Commercial Code Reform (the "Interim Report"), legislation recently enacted amending the Code that is expected to become effective in October (the "June Amendments"), and proposed new listing rules announced in July by the Tokyo Stock Exchange and Osaka Securities Exchange (the "Listing Reforms"). We then examine the implications of the proposed reforms for investors in Japan.

Interim Report Reform Proposals
The proposals described below were published by the MOJ for public comment as part of the Interim Report on April 18. The public comment period expired on May 31. According to the MOJ, once changes reflecting public comment have been incorporated into the proposal,the provisions of the Interim Report concerning stock options and electronic notification of shareholders will likely be forwarded to the extraordinary Diet session for deliberation this fall, and the remainder of the reform proposals will be submitted to the regular Diet session in Spring 2002.

Capital Increases, New Share Issuances
Under the reform proposal, closely held corporations (corporations that restrict transfer of shares in their articles of incorporation) may opt out of the current rule limiting the company's authorized shares to be not more than four times issued shares. In addition, however, the MOJ has proposed a yet-to-be-determined threshold on new issuances of shares applicable to all other corporations, above which shareholder consent would be required, even if there are sufficient authorized shares under the articles of incorporation.

Stock Option Plans
The Interim Report proposes a broad restructuring of the manner in which all subscription rights are granted under the Code. Included under this proposal are new rules governing the grant of stock options. Currently, the Code allows corporations to issue two types of stock options: treasury stock options and warrant stock options. Under both such programs, unless special approval from the Ministry of Economy, Trade, and Industry is obtained, corporations are limited to issuing options (1) to employees or directors of the corporation, and (2) in an amount exercisable for a maximum of 10 percent of the corporation's issued and outstanding capital stock. As a result of these limitations, corporations have resorted to a third method: that of shinkabu hikiuke kentsuki shasai, or the issuance of bonds with detachable warrants. The warrants, once detached from the bonds and repurchased by the corporation from the bondholder, may be granted to third parties as well as employees or directors. This type of warrant bond plan has several major drawbacks, including (1) the administrative burden in connection with issuing the bonds, (2) relatively high transaction costs to the corporation, (3) unfavorable tax treatment to recipients of the warrants, and (4) in the case of non-employee and non-director recipients, a requirement that such warrants be exercised in the fiscal year prior to the fiscal year in which the corporation intends to publicly list its shares.

The current MOJ proposals would eliminate limits on eligible grantees and the number of stock options available for grant under statutory option plans. The reform proposals also include a provision that would eliminate the Code requirement providing that a corporation name all stock option grantees at a shareholders meeting. Shareholders approving such stock options need only resolve whether the underlying security is par or non-par value stock, and what type and number of shares will be made available.

Share Capital Attributes
The Interim Report also proposes allowing corporations to issue securities with more complex terms than previously possible by:
* permitting corporations, in their articles of incorporation, to grant separate classes or series of stock special veto rights, as well as the right, in the case of closely held corporations, to vote for subsets of directors,
* allowing corporations, in their articles of incorporation, to use a formula or other method to compute dividends and distributions, and
* raising the Code limit on non-voting shares from one-third to one-half of the total of outstanding shares.

Corporate Governance
Another proposal in the Interim Report is an optional corporate governance system under which a corporation may provide in its articles of incorporation for audit, nomination, and compensation committees of the board, each with a majority of outside directors. If the company adopts this system, it may dispense with the current Code requirement to maintain a statutory auditor.
The proposed reforms would require all "large corporations" (those with over JPY500 million paid-in capital, public or private) to have at least one outside director. Other proposed changes include:
* permitting the establishment of an executive committee composed of board members which, with the participation of a statutory auditor (assuming participation in the "old" system of corporate governance), may approve matters otherwise reserved for action by the entire board,
* permitting board and shareholder action by unanimous written consent in addition to in-person meetings, and
* requiring the board to approve performance-based director compensation.
The proposed changes would lower the quorum required at a shareholders meeting for approval of an extraordinary resolution (those required for significant events such as a sale of the company or merger) from the currently required level of one-half to one-third of outstanding shares. In addition, the proposals would (1) lengthen the shareholder meeting notice from two weeks to four weeks, (2) change the deadline for receipt of shareholder proposals before the meeting date from six weeks to eight weeks, (3) allow electronic voting of proxies and online voting at shareholder meetings, and (4) permit electronic dissemination of proxy materials.

In-kind capital contributions
The proposals would eliminate the requirement for court-supervised inspection of in-kind capital contributions. In addition, however, the proposals include a provision that, in lieu of a court-appointed appraiser:
* the appraisal must be performed by a lawyer or CPA, and
* the lawyer or CPA performing the appraisal would be held strictly liable for any substantial discrepancy, and may be held responsible for any damages incurred by the corporation as a result (this provision is currently being reviewed further by MOJ for modifications).

June Amendments
Most of the provisions in the June Amendments address the rules applicable to a corporation's repurchase of its outstanding shares. The provisions were passed principally in order to facilitate the reduction in corporate cross-shareholding by giving corporations the ability to hold treasury stock, reflect it on its balance sheet, and use the stock for other purposes such as M&A. Of more immediate interest to investors and discussed in more detail below are the provisions in the June Amend-ments that would eliminate (1) the distinction between par and non-par value stock, (2) the requirement that a corporation's net asset value per share be at least JPY50,000 after effecting a stock split, and (3) the minimum capitalization requirements upon formation of a corporation (currently JPY10 million).

Listing Reforms
The current listing rules of the Tokyo Stock Exchange, Osaka Securities Exchange (including Nasdaq Japan), and the OTC market (Jasdaq):
* prohibit a company from issuing shares to third parties during the fiscal year in which the company publicly lists its shares, and
* impose a mandatory lockup on shares issued during the fiscal year prior to the year of listing. Under this rule, conversion of preferred stock and exercise of options or warrants for common stock are each considered a new issuance to third parties.
The effect of the current rule is that preferred stock and other convertible securities must be converted or exercised by the end of the fiscal year immediately prior to the year in which the company plans to list its shares. (Currently, the rule does not apply to warrants or options issued to employees or directors.) Consequently, key economic rights associated with convertible preferred stock (such as a dividends or liquidation preference) terminate well before the closing of an initial public offering, and before it is clear even whether such an offering will be practicable in light of market conditions or other factors. On July 17, the TSE and OSE announced that the prohibition on a company's issuance of new shares to third parties during the fiscal year in which the company publicly lists its shares will be abolished so long as the holders of such securities agree to a six-month lockup from the date of listing. The related prohibition on the conversion or exercise of convertible securities will also be lifted. These reforms are expected to take effect this fall.

Implications for Investors
Taken together as a whole, the proposed reforms represent a positive step, since they provide enhanced flexibility, efficiency, and certainty when structuring transactions which are subject to the Code. First and foremost, by eliminating the distinction between par and no-par stock, removing the post stock-split net asset requirement, and eliminating the requirement that limits the number of authorized shares to four times outstanding shares, the reforms should significantly reduce transaction costs associated with company financings. Secondly, by allowing corporations to grant veto rights to certain classes of stock and by implementing important changes to the listing rules, the reforms provide greater certainty that critical protections sought by investors are in fact enforceable against the corporation for an optimal period of time (i.e., in the venture-backed company context, until the closing of an IPO). Generally speaking, under current Japanese corporate law, investor rights must be set forth in the articles of incorporation in order to be fully enforceable against the company, and under pre-June Amendments practice, the range of article amendments which regulators would accept was severely restricted. Finally, as attitudes in Japan change towards equity compensation, the stock option reforms will enhance corporate flexibility by providing alternative methods to attract and retain the best employees.
From a foreign investor's perspective, there is no question that Japan has more to do to catalyze M&A activity. An example which has been widely publicized in recent months is an acquirer's inability to use shares which are listed on a foreign exchange as consideration in a stock-for-stock acquisition of a Japanese company (kabushiki kokan). As some of our readers know, acquirers using domestically listed shares are accorded favorable tax treatment in exchange acquisitions.

Unfortunately, the proposed reforms contained in the Interim Report and the June Amendments do not address this issue. Notwithstanding this and other shortfalls, the proposals contained in the Interim Report, the June Amendments, and the Listing Reforms are useful to the investor community, and represent a step in the right direction. While many of the proposals are aimed at streamlining corporate procedures, others are more substantive and should have an immediate impact on transaction structuring.

Initial share issuance, capital structure reforms
These reforms should benefit founders and investors, whether foreign or domestic, in several respects. First, initial transaction costs associated with the establishment of a corporation are reduced substantially by elimination of the JPY10 million minimum initial capitalization requirement (200 shares at JPY50,000 per share issuance price). Founders and early-stage investors seeking to achieve US-style capital structures by issuing a relatively large number of shares initially at a low price will be able to do so more efficiently without having to effect, as is currently necessary, multiple consecutive share issuances, capital increases, and associated board and shareholder meetings.

There are two major drawbacks to the proposed reforms in this area. First, the reforms do not eliminate the current requirement that all new stock issuances by closely held companies be authorized by an extraordinary shareholders resolution if a pro rata portion of such newly issued shares are not offered to the existing shareholders. Secondly, the Interim Report contains a provision which would limit the number of shares that may be issued by non-closely held corporations pursuant to a board resolution to 20 percent of the corporation's then outstanding shares. Beyond this threshold, shareholder approval will be required. In both cases, such a requirement appears unnecessary, given general director fiduciary duties and the fact that shareholders may have already approved authorization of the shares to be issued.

Share Capital Attributes
Among the most important proposed reforms in the Interim Report is the proposal allowing a corporation to designate voting rights in its articles of incorporation. Investors that seek special approval rights, but hold less than 33 percent of the outstanding capital stock of a Japanese company, have had to assume the risk that contractual voting rights may not be ultimately enforceable against the company. This is because under the Code, a shareholder that holds less than 33 percent of the outstanding stock is unable to block an extraordinary shareholders resolution (which only requires a two-thirds shareholder vote). As noted above, the Code currently does not permit companies to designate special voting rights as an attribute of a particular class or series of stock in their articles.

The MOJ commentary on this point notes that the proposal is intended to ensure the validity and enforceability of shareholders agreements that have become a common feature of venture capital financings in Japan. Although the contents of this portion of the proposal, and the accompanying commentary, may be generally viewed as favorable to investors, the MOJ has also signaled that it is approaching this measure cautiously, in fear of abuses of these rights. In this regard, the proposal provides a non-exclusive list of examples of such approval rights that may not be included in a company's articles of incorporation in the designation of a particular class of stock. These matters must be approved by the general meeting of shareholders or the board of directors as a whole, and include:
* election or removal of auditors and directors (despite the affirmative provision appearing elsewhere in the Interim Report permitting shareholders of certain classes or series of stock in closely held corporations to be granted the right to elect and remove subsets of directors),
* board approval of transfers of stock, and
* liquidation or winding up of a corporation.

In addition, the Interim Report states that the proposal will continue to be reviewed for other items that may merit inclusion in the foregoing list.

Since the TSE and OSE are proposing to lift the requirement that convertible securities and options and warrants granted to non-employees and directors must be exercised by the end of the fiscal year immediately preceding the fiscal year in which a company publicly lists its shares, Japan will for the first time have a corporate regulatory environment which, while not ideal in all respects, generally recognizes and promotes investor interests. Overall, these reforms will enable investors to achieve a capital structure that more closely approximates that available in overseas jurisdictions. This should encourage more foreign direct investment in Japanese emerging companies and ultimately, with more issued shares afforded by the relaxation of par value limitations, enhance liquidity in the Japanese markets.

Equity Compensation
As discussed earlier, the Interim Report proposals eliminate the limits on both the number of options granted by a corporation and the persons to whom such options may be granted. This measure, together with the proposed reforms easing restrictions on capital increases, enhances investor flexibility in planning a company capital structure that includes appropriate incentives for management to recruit and retain the best employee talent. In addition, the reforms will also enable corporations to creatively enhance transactions with trade partners and customers, effectively allowing more easily for equity "kickers," such as non-director/employee warrants or options in a broad range of transactions. With the proposed new ability for boards of directors to act by unanimous written consent, coupled with the elimination of the Code requirement that all stock option recipients be named individually at a shareholder meeting, these reforms would greatly streamline the administrative burden associated with stock option programs.

The Wind-up
While the proposals in the Interim Report and those adopted in the June Amendments are a start, much remains to be done. From a foreign investor's perspective, many key remaining reform points involve M&A, such as:
* an express acknowledgment that triangular mergers are permissible where a Japanese acquisition vehicle uses shares of its foreign parent as consideration for the purchase of a target's capital stock in a share-for-share exchange (kabushiki kokan).
* complete harmonization between the Commercial Code and the Tax Code so that share-for-share exchanges receive preferential treatment -- irrespective of whether foreign or domestic parties are involved.
* permitting an acquirer to cause the compulsory tender of shares by minority shareholders after a successful acquisition, so that companies can be completely privatized for stock or cash and such acquisitions can result in the acquirer holding 100 percent of the target's outstanding shares.
* Tax Code/Commercial Code harmonization in connection with stock option reform. In the wake of the Koizumi administration's spirit of reform, it is hoped that such additional reforms will be forthcoming. @

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