How does the Appraisal Right with the Concept of the Fair Value Including Synergies Work?: Lessons from Japan

Abstract

This article presents how the appraisal right, with the concept of the fair value which includes synergies, has worked in Japanese corporate law. The appraisal right gives dissenting shareholders the ability to protect their interests. The Delaware courts calculate a fair value by excluding synergy effects in appraisal proceedings. One can criticise the exclusion of synergies because the petitioners of the appraisal right might receive less than the merger price. It would be interesting to analyse how the situation changes if the fair value includes synergies. Japanese corporate law gives a good illustration for this. The revision of the Companies Act of Japan in 2005 enhanced the role of the appraisal right by empowering the Court to include synergy value into the determination of fair value. However, Japan's Court developed the doctrine to use the deal price as a fair value with a relatively lax review of the fairness of the deal process. This has resulted in an unattractive situation for petitioners of appraisal remedies, because they rarely gain profits through the appraisal remedy. Empowering minorities in black letter law does not necessarily strengthen minority protection in reality.

Introduction

The Companies Act of Japan and the Delaware General Corporation Law (DGCL) have differences in their definition of the appraisal right.¹ They differ on whether to reflect the synergy effect expected from the merger in the concept of ‘fair value.’ Fair value is a concept that indicates the price when a company purchases the shares of the shareholders who have exercised their appraisal right. The Delaware courts calculate a fair value by excluding synergy effects.² Japanese courts calculate it as follows: (1) If the corporate value does not increase by the merger, the Court calculates the value of the stock that would have been prevalent on the date of exercising the appraisal right had the merger not taken place (ie, ‘hypothetical value’).³ However, (2) if the corporate value increases by the merger, the Court calculates the value of the shares reflecting the synergy effect on the date of exercising the appraisal right (ie, ‘synergy value’).⁴

Moreover, there is no ‘market-out’ rule in Japan.⁵ Under the market-out rule in Delaware, appraisal rights are not available for shareholders who hold those shares that are either (i) listed on a national securities exchange or (ii) held by more than 2,000 holders.⁶ As an exception to the market-out rule, appraisal rights are available for such shareholders if the merger consideration is anything other than shares of other corporations either listed on a national securities exchange or held by more than 2,000 holders.⁷ Thus, the dissenting shareholders of the target corporation, which is listed on the New York Stock Exchange, are eligible to exercise appraisal right in a cash merger in which the consideration paid in the merger is cash, but not in a stock-for-stock merger in which the consideration paid in the merger is the stock of the surviving listed corporation. In contrast, the Japanese appraisal rights are available for the dissenting shareholders whose shares are listed on the Tokyo Stock Exchange not only in the cases of cash mergers but also in the cases of a stock-for-stock merger of the listed companies. This point is also different from Delaware.

Despite these differences, the appraisal right in both laws converges rapidly in several respects. First, it is common in Japan and Delaware that the recent amendment of the corporate law has introduced the system in which the corporation has the right to make a preliminary payment of the value that the corporation finds fair. It aims to prevent the accrual of interest on the fair value. Japan revised the Companies Act in 2014 by introducing the new rule in which the respondent company can pay the petitioner shareholder the amount that the company deems fair value.⁸ In Delaware, the revision of DGCL in 2016 introduced a similar new rule into Article 262(h) of DGCL.⁹ Under the new rules in both jurisdictions, if the company makes a preliminary payment of the fair value, the interest shall accrue on the difference between the fair value determined by the Court and the amount paid by the corporation in advance.¹⁰ This rule might discourage appraisal arbitrage, the petitioner's strategy of purchasing shares for the purpose of exercising the appraisal right.¹¹

Second, in both Japan and Delaware, the recent courts’ decisions used the deal price as a fair value even in the deals between parties with conflicting interests, such as the management buyouts (MBOs) and the cash-out deals by a controlling shareholder. If the Court deems the deal process fair, it tends not to make its original calculation of the fair value but rely on the deal price.¹²

Third, both jurisdictions’ Supreme Court refer to the possibility of using stock market price when calculating the fair value. Japan's Supreme Court held that it is rational to use the market price as a basis for determining the fair value. The reason is that it reflects the fundamental value of the corporation.¹³ Although the Delaware courts had not traditionally used the market price in the appraisal cases,¹⁴ the Delaware Supreme Court recently held that it supports the efficient market hypothesis¹⁵ and, in another case, affirmed the Court of Chancery's judgment adopting the unaffected market price as the fair value of its stock as of the date of the merger.¹⁶

The development of the laws on the appraisal right in both jurisdictions shows a tendency to approach even though the concept of the fair value differs. This is because the issues inherent in the appraisal right are common in both Japan and Delaware; thus, their solutions are also common.¹⁷ Calculating a stock's value cannot provide the unique correct answer. The valuation experts usually create the so-called football field chart showing the range of the corporate value, but they do not report one specific price. Nevertheless, the Court must determine the specific price as a fair value. The stock value calculation by the discounted cash flow (DCF) analysis submitted by the shareholders and the company, which are the trial parties, tends to use favorable figures for themselves. The price submitted by the shareholder's side is often many times higher than the price submitted by the company. It is troublesome for the Court to determine whether one or the other is correct or wrong.¹⁸

On the one hand, if this value is too low, the minority shareholders’ interests may be harmed. On the other hand, if this value is too high, there is a risk that the incentive for exercising the appraisal right will increase too much. Tasks requiring this delicate balance are challenging for courts because judges are law-trained but not finance-trained. Therefore, when some objective indicators are available, it is reasonable for the courts to utilise them and avoid their own calculation.¹⁹ It is understandable that the Court formulated the rule to rely on the deal price if the deal process was as fair as the arms’ length deals.²⁰ This formulation frees the Court from such a delicate task. Moreover, since the parties to the lawsuit cannot control the stock market price, the stock market price is more objective than the DCF analysis.²¹

The important difference between Delaware and Japan is whether to include or exclude the synergy effect. The Delaware courts calculate a fair value by excluding synergy effects in appraisal proceedings.²² Recent Delaware cases showed the Court's tendency to rely on the ‘deal price minus synergy’ as the fair value if the deal process was fair. For example, if the merger price is 100 and the synergy effect of the merger is 20, the fair value would be 80 under the deal-price-minus-synergy formula.²³ The petitioner would lose 20 by exercising the appraisal right instead of selling the stock at the market price of 100, reflecting the merger effect. One can criticise this formula for limiting the ability of the appraisal right to protect minority shareholders because the petitioners of the appraisal right might receive less than the merger price.²⁴ Then, it would be interesting to analyse how the situation changes if the fair value includes synergies. Japanese corporate law gives a good illustration of this interest. The revision of the Companies Act of Japan in 2005 enhanced the role of the appraisal right by empowering the Court to include synergy value in determining the fair value.²⁵ It aimed to enhance the protection of dissenting shareholders, especially from the unfair distribution of synergies due to conflicts of interest.²⁶

Although the literature hotly debates the appraisal remedy in Delaware,²⁷ less is known about the development in Japanese cases of appraisal rights and what happened by introducing synergy value into the definition of fair value.²⁸ This article fills this gap and demonstrates how the revision of Japan's Companies Act in 2005 expects the Court's scrutiny of the deals by calculating the synergy value, but, surprisingly, how differently the case law has developed from the legislators’ expectation. Facing the troublesome role of judging the adequacy of the distribution of deal surplus, Japan's Court developed the doctrine to use deal price as a fair value with a relatively lax review of the fairness of the deal procedure.²⁹ This has resulted in an unattractive situation for petitioners of the appraisal remedy because they can rarely gain profits through the appraisal remedy. This shows that empowering the minorities in the black letter law does not necessarily strengthen minority protection in reality.

The article will proceed by first giving a brief overview of the history of the appraisal right in Japan. It then examines the judicial precedents on fair value. Thereafter, the article makes a comparative analysis of the conditions to use the deal price to determine the fair value between Delaware and Japan, before analysing Japan's courts’ current attitude toward the passive review of the fairness of the deal. The final part of the article states the conclusion.

Overview of History of the Appraisal Rights in Japan

Introduction of the appraisal right by the amendment in 1950

The appraisal right was introduced into Japanese corporate law by the amendment of the Commercial Code in 1950 for the first time.³⁰ This introduction occurred because, at that time, Japanese law followed American law (especially the Illinois Business Corporation Act of 1933) under the direction of General Headquarters.³¹ The Japanese provisions initially provided for dissenting shareholders to be entitled to the fair value that the shares would have if there were no shareholder meeting resolution approving mergers. The Court had to determine the hypothetical value assuming no such merger, although a shareholder meeting's resolution approved the merger.³²

The rationale of the appraisal right introduced in 1950 was the protection of the economic interests of minority shareholders against the majority's decision.³³ The revision of 1950 was meaningful to protect shareholders against the negative side of the merger. As Figure 1 shows, suppose that the unaffected market price was 300. At the announcement of the merger, the market price went down to 200 because the merger decreased the total firms’ value. If the dissenting shareholders exercise the appraisal right, they can receive a fair value of 300. This system protects the dissenting shareholders from such a value-decreasing merger. Contrary to the reform of 2005, there was no viewpoint of fair participation to the merger's positive side, such as the distribution of the synergies to the dissenting shareholders, in 1950. Therefore, there was no argument about whether the appraisal remedy should distribute the profits arising from the merger at that time.³⁴

Figure 1. Value-decreasing Merger and Hypothetical Value

Enhancing the role of the appraisal right by the reform in 2005

The reform of the Companies Act in 2005 enhanced the role of the appraisal right.³⁵ It changed the concept of the fair value to enable the Court to reflect not only the hypothetical value but also the synergy value. The wording of the provisions of the appraisal right was amended in 2005 from ‘fair value that the shares would have had if there had been no shareholder meeting's resolution approving the merger’ to just ‘fair value’ to facilitate the consideration of the distribution of synergies in determining the fair value. The revision gives the measure of a remedy to dissenting shareholders dissatisfied with the synergy distribution. The purpose of the 2005 reform of appraisal rights was to provide a remedy that protects minority shareholders from freeze-out mergers, which were also made clearly available for the first time by the Companies Act of 2005.³⁶

Suppose the total synergy from the merger between Firm A and Firm B is 50, and the merger price paid to Firm A's shareholders is 110, of which 100 is the stand-alone value and 10 is the distributed synergy effect (see the left side of Figure 2). Under the current Japanese law, if the Court determines the deal price does not reflect a fair distribution of synergy, it can determine the fair value to be 120, which is higher than the deal price and the stand-alone value.

Figure 2. Fair Value Reflecting Synergy Value

This solution is essential, especially in a merger case with conflicts of interest, such as the merger between the parent and subsidiary company.³⁷ As the parent company controls the subsidiary company, it is possible, in theory, to determine the deal price to be unilaterally advantageous to the parent company. In an extreme case where the parent company abuses its control rights, the parent company receives all of the synergistic value, and the minority shareholders of the subsidiary company receive no upside return from the merger.

Of course, the directors of each company are obliged to negotiate on behalf of each company's interests. If the director breaches a fiduciary duty in negotiating the deal, the director is liable for damages. However, in Japan, the content of the directors’ fiduciary duties regarding mergers and acquisitions is unclear. Contrary to the experience of Delaware³⁸, there have been few cases in which the shareholder has sued the directors or the controlling shareholder; consequently, the case law has remained undeveloped.³⁹ Thus, if the shareholder files a lawsuit against the director in such a case, the standard of review on fiduciary duties is unclear in Japan. Moreover, Japanese law does not clarify whether the controlling shareholder owes the fiduciary duty to the company or to the minority shareholders.⁴⁰

Therefore, the revision in 2005 enhanced the role of the appraisal right to protect the minority shareholders.⁴¹ Under the appraisal remedy, the petitioner need not establish the breach of the fiduciary duties. Thus, strengthening the appraisal right does not need difficult rule-making to clarify the fiduciary duties. The appropriate institution in charge of clarifying the content of the fiduciary duty is not the legislator but the Court. The Court determines the fair value regardless of whether the directors breached the fiduciary duties or not. The Court was left with the task of determining a fair value including synergies, which is highly challenging. For the Court, determining fair value should be as difficult as clarifying the content of the fiduciary duties. The Court formed its framework for determining fair value through decisions in several cases. Such a framework is outlined below.

Judicial Precedents on Fair Value

This section describes the judicial precedents on the meaning of fair value under Japanese corporate law. How much will the company have to pay if the dissenting shareholder exercises the appraisal right? The Companies Act refers to ‘fair value’ in the statute's text. Its concrete meaning is left to interpretation. Since the reform of the Companies Act in 2005, the Court understands that dissenting shareholders are entitled to: (i) a fair value that the shares would have had if there were no resolution approving the merger (hypothetical value); or (ii) a fair value that reflects synergies arising from the merger (synergy value).

The purpose of the appraisal right

In the TBS case,⁴² the Supreme Court clearly stated the purpose of the appraisal right for the first time after the amendment in 2005. This case was about a corporate split⁴³ in which TBS, a broadcasting company, succeeded to the wholly-owned subsidiary some of TBS's rights and obligations.

The Supreme Court held that the purpose of the appraisal right was to make it possible to conduct an essential change to the foundation of the company organisation, such as a merger, by a majority vote at the general shareholders’ meeting.⁴⁴ Moreover, it held that the appraisal right gives dissenting shareholders the opportunity to leave the company and secures for them an economically equivalent situation to where there were not a merger.⁴⁵ It held that if the corporate value increases due to the merger, the appraisal right will protect the shareholders’ interests by the Court's determination of the fair value that reflects the appropriate distribution of the synergies to the dissenting shareholder.⁴⁶

The issue of the distribution of synergies arises if and only if the merger increases the corporate value compared to both corporations’ pre-merger value. Based on this purpose, the Supreme Court developed the doctrine by separating cases depending on whether the corporate value increases due to the merger. The reason for paying attention to whether the corporate value is increased is because of the purpose of the 2005 amendment.

When there is no increase in corporate value: hypothetical value

Concept

In the TBS case, the Supreme Court held that the Court must determine the hypothetical value as a fair value when there is no increase in corporate value due to the merger.⁴⁷ It held that there is no room to consider an appropriate distribution of increased corporate value if there is no increase in synergies or other corporate values due to the merger.⁴⁸ It did not mention how to calculate the synergy value when the merger increases corporate value. The reason for this is that there was no increase in corporate value in the TBS case. The Court held that this deal did not increase or decrease firm value as this was a deal between the parent company and the wholly-owned subsidiary company.⁴⁹

This decision framework was also taken by the Supreme Court decision in the Intelligence case,⁵⁰ one week after the TBS case. The Intelligence case was a share exchange⁵¹ between the parent and subsidiary companies. The dissenting shareholders of the subsidiary exercised their appraisal right. The petitioner shareholders argued that the share exchange was detrimental to their corporate value and that the hypothetical value should be calculated. They argued so because there was, allegedly, no sufficient disclosure of information to shareholders and the process of determining the exchange ratio lacked fairness. The respondent company argued that the share exchange in this case would not damage its corporate value because the parties have conducted independent and diligent negotiations, the process of determining the terms of the share exchange is fair, and the terms of the share exchange are objectively reasonable. The Tokyo High Court recognised that this share exchange damaged the corporate value since the main reason for the continued decline in the stock price of the subsidiary was the announcement of the share exchange, even though the general fairness of the share exchange procedure and the objective reasonableness of the terms of the share exchange are prima facie clear.⁵² Thus, the Supreme Court held that the Court must calculate the hypothetical value.⁵³

Calculation

Then, the next issue is how to calculate hypothetical value. The Court must determine the hypothetical value because the deal decreases the corporate value. Thus, the deal price is not an appropriate indicator for calculating the hypothetical value because the hypothetical value, by definition, refers to the value of the stock if the deal had not taken place.

It is necessary to determine on what date (ie, ‘base date’) the fair value must be calculated. In the cases of a stock-for-stock deal, the Supreme Court in the TBS case held that the base date of calculation is the day on the dissenting shareholder's exercise of the appraisal right because its exercise gives rise to a similar legal relationship as if a sales contract were formed between the dissenting shareholder and the company by operation of law.⁵⁴ After its exercise, the company is obliged to purchase the shares at fair value whereas the dissenting shareholder cannot withdraw their share purchase demand without obtaining the company's approval (Kaishahō [Companies Act of Japan] Article 785, paragraph 6).⁵⁵

In its reasoning, the Supreme Court held that other candidates of the base date are not adequate because they will result in an unreasonable distribution of risk to the dissenting shareholder. Its logic is as follows. Suppose that the fair value is to be determined on a day that comes later than the day on which the dissenting shareholder has exercised the appraisal right. The dissenting shareholder would have to assume the risk of share price fluctuations after the share purchase demand. The market price may fluctuate due to factors other than the merger, such as the general factors that impact the market as a whole. Even though the dissenting shareholder cannot withdraw their share purchase demand at their own will, it is unreasonable to make them stand in such a situation.⁵⁶ Conversely, suppose that fair value is determined as of the day the relevant resolution is adopted. This case is also unreasonable because the dissenting shareholder would assume no risk of fluctuations in the stock market price after the resolution's date.⁵⁷

Although the Supreme Court did not elaborate on the last point, one can understand that the Court is concerned with the following situation: if the market price were to decline following the resolution, the shareholders could exercise the appraisal right and be able to obtain the unaffected market price higher than the affected market price on the date when the dissenting shareholder exercises the appraisal right. If the market price rises since the resolution, the shareholders will not exercise the appraisal right but will sell their shares at a higher market price than that at the date of the resolution. Therefore, the Court held that it is appropriate to construe that the fair value is determined as of the day that the share purchase demand is made.⁵⁸

The base date issue is significant, especially in cases where the Court refers to the stock market price. The Japanese Court usually uses the market price, if available, rather than utilising DCF analysis.⁵⁹ In the TBS case, the Supreme Court held that it is within the Court's discretion to refer to the market price to calculate the hypothetical value.⁶⁰ If the Court uses the DCF analysis, the difference in the base date within several weeks will not result in a different valuation. However, if the Court refers to the market price, the market price could dramatically differ between months, weeks, days, hours, minutes, or even seconds. Moreover, this question is essential, especially when the merger consideration is a stock. Generally speaking, in the case of a cash merger, the market price of the target company will converge to the announced deal price and not show a dynamic fluctuation. However, in the cases of a stock-for-stock merger, the market price will fluctuate depending on the daily change in both companies’ firm value. As mentioned above, the Supreme Court has clarified the base date in the cases of stock-for-stock deals, whereas no clear ruling was made in the cash-out deals.

Then, the next question arises at what period of the market price the Court can refer to calculate the fair value as of the base date. The market price after the deal's announcement is useless for calculating the hypothetical value because it is affected by its announcement. Thus, if the Court refers to the market price for this purpose, it must refer to the market price before its announcement. However, there is a gap between the announcement date of the deal and the base date for calculating the fair value. Using the market price as of the announcement date is not consistent with the above-stated reasoning of the Supreme Court on the issue of the base date. Then, the Supreme Court held that it is within the discretion of the Court to use and make corrections in the market price as of the announcement date.⁶¹ It held that it is reasonable to use regression analysis (ie, using the market model, for example) as such corrections to exclude the impact of factors other than the deal itself.⁶²

One can argue that a few months would have elapsed between the announcement date of the deal and the day that the appraisal rights were exercised, and consequently, the accuracy of the estimated stock price by a market model would be doubtful at best.⁶³ Yet, if the Court made no corrections to the unaffected market price, the Court would contradict their interpretation of the law.⁶⁴ Thus, we must accept a certain amount of inaccuracy in making such corrections.⁶⁵

When the corporate value increases: synergy value

The Supreme Court, in the Tecmo case, held that the Court must determine the synergy value as a fair value when the corporate value increases due to the merger.⁶⁶ Then, the next question is how the Court shall determine the synergy value. At the time of the lawsuit of the appraisal right, the synergy effect is not realised. Thus, it takes a while to be able to observe the synergy effect. Furthermore, supposing that the Court could observe the amount of the synergy value, there is no theory on how to divide it equitably.⁶⁷

In general, the distribution of the residuals of the deals is determined through the negotiation among the deal's parties⁶⁸ and is rarely decided by the Court. For example, if you buy a used car from a friend, the deal price is fixed by negotiation. As Figure 3 shows, the Court will not evaluate the reservation prices and will not determine what the deal price should be unless, for instance, your friend scams you. Therefore, case law has not developed a theory of equitable distribution of the deal surplus. However, the Japanese appraisal right's concept of synergy value requires the Court to make such an intervention.

Figure 3. Distribution of Deal Surplus

The Japanese Court developed the framework for determining the synergy value depending on whether the deal was at arms’ length or not. This framework minimises the area where the Court must make the original calculation of the synergy value.⁶⁹

Arms’ length case: deal price as a fair value

The Supreme Court used the deal price as the fair value in the Tecmo case, which was an arms-length case of a ‘share transfer.’ A share transfer is one variation of a merger: share transfer is any transfer whereby one or multiple companies cause all of their issued shares to be acquired by a newly incorporated company.⁷⁰ In the Tecmo case, there were no conflicts of interest between the parties of the deal. The Supreme Court held that the fair value, in cases where the corporate value increases, means the price the shares would have had on the date of exercising the appraisal right if the share transfer ratio specified in the share transfer plan had been fair.⁷¹ The Court focused on the fairness of the share transfer ratio because if the corporate value increased due to the share transfer, the corporate value after the share transfer would have been distributed to shareholders by allocating the new stock.⁷²

Regarding whether the ratio was fair, the Supreme Court divided the case depending on whether there was a special capital relationship⁷³ between the parties to the deal. It held that, in general, if a share transfer plan is made by companies that do not have special capital relationships with each other, the Court should respect the judgment of the directors and the shareholders.⁷⁴ As the directors owe fiduciary duties to each company, and there are no conflicts of interest, the directors would be likely to prepare a plan in line with the company's interests.⁷⁵ Moreover, shareholders vote in favour of the share transfer at the shareholders' meeting if they determine that the share transfer ratio is fair, considering how the share transfer will change their interests.⁷⁶

Based on the above, the Supreme Court set the specific criterion for judgment as follows. The ratio of such a share transfer shall be fair when the share transfer between companies without any special capital relationship is made effective through the procedure generally deemed fair, such as the case where the shareholder meeting was legally held, and the disclosure of the information was appropriate.⁷⁷ However, this is not the case if there is any particular circumstance to acknowledge that the shareholders’ reasonable judgment was hindered.⁷⁸ In conclusion, the Supreme Court in the Tecmo case decided to respect the judgment of the shareholders and the directors.⁷⁹ It held that the decline of the target company's market price after the announcement of the deal does not reflect the said particular circumstance because market fluctuations occur due to various factors.⁸⁰

Given that the ratio of share transfer is fair, the market price would be the most reliable evidence for determining synergy value. In the Tecmo case, the Supreme Court held that it is within the Court's discretion to either use the base date's market price or an average market price of a period near that date.⁸¹

From the dissenting shareholder's perspective, this way of determining the synergy value means that exercising their rights does not lead to any financial gain. In this case, there is virtually no difference between the selling price of the stocks in the market and what the shareholder could receive in terms of financial benefits by exercising their appraisal rights. Of course, if the liquidity in the market is low, there is no guarantee that they could sell all their stocks at the same desired price. In contrast, with appraisal rights, there will at least be some interest, and it may look slightly more attractive to the dissenting shareholder to exercise this right. However, with the reform in 2014 mentioned above, there is now a preliminary payment system in place; therefore, such benefits from interests can no longer be obtained. In sum, if the corporate value has increased through a merger, and the distribution of that value is fair, the use of the market value as discussed above functions as a deterrent for the dissenting shareholder by denying any substantial relief. One can argue that this approach is reasonable because there is no reason to give relief beyond the market price to dissenting shareholders as long as the merger is conducted fairly.⁸²

Interested deals: deal price or the judge's calculation

The Supreme Court also uses this framework when the deal structure has conflicts of interest, such as the controlling shareholder's freeze-out of minority shareholders and MBOs.⁸³ If the proper measures to mitigate the conflicts of interests functioned well, the process of the deal could be determined as fair. Then, when the deal structure in the freeze-outs or MBOs is a kind of cash merger, the Court uses the deal price directly as synergy value because the deal price is reliable. Contrary to stock-for-stock deals where the Court needs to convert the value of a stock to cash to determine the synergy value such as in the Tecmo case, the Court need not make any calculation in the cash merger cases where the deal process is fair.

The Supreme Court illustrates this framework well in the Jupiter Telecom case.⁸⁴ In the Jupiter Telecom case, the controlling shareholders made a two-step freeze-out deal: the first was via a tender offer, and the second was via a cash-out procedure in the Companies Act.⁸⁵ The controlling shareholders set the price of both steps equal. The Supreme Court held that the Court must determine the value of the share equal to the tender offer price if the deal is made effective through the generally deemed fair process.⁸⁶ This fair process involved measures to exclude the effect of the decision-making process becoming arbitrary due to the conflicts of interest between majority and minority shareholders, such as obtaining opinions from an independent special committee and experts.⁸⁷ Furthermore, a fair process included the controlling shareholders clearly stating that the shares possessed by shareholders who did not apply for the tender offer would be acquired at the same price as the tender offer,⁸⁸ making the tender offer uncoercive.

In contrast, the Court made its original calculation of the value of the share if the deal process was not fair. The Rex Holding case⁸⁹, an MBO case, is an excellent example of this type of case. In this case, the process was not transparent enough. The business plan and the expert's report of the valuation of the shares were not disclosed. The buyer used phrases that may have had a coercive effect on the tender offer.⁹⁰ The Tokyo High Court decided the fair value at 336,696 JPY per share, much higher than the deal price of 230,000 JPY per share.⁹¹ The Tokyo High Court calculated the objective value (stand-alone value) as 280,805 JPY, the average unaffected stock market price prior to the deal's announcement.⁹² The Tokyo High Court then calculated synergy value by adding 20% to the stand-alone value and arrived at a value of 336,696 JPY (=280,805 × 120%).⁹³ The Tokyo High Court used a figure of 20% because the premiums in other MBOs during those days ranged from 16.7% to 27.4%, averaging 27.05%.⁹⁴ The Supreme Court upheld this decision by the Tokyo High Court.⁹⁵

Comparison of The Conditions to Use the Deal Price for Determining the Fair Value

Japanese precedents are distinctive in that they appear to have established a rule of withholding court intervention subject to the fairness of the deal process. The Japanese Supreme Court made it clear that, in cases where procedures generally accepted as fair were taken, the deal price was respected for determining the fair value of the appraisal right. Of course, as in the Rex Holding case, the Court sometimes calculates the synergy value without using the deal price. Moreover, as in the Intelligence case, the Court sometimes calculates hypothetical value using the market model, requiring the judges to understand finance and econometrics. However, such cases have become extremely rare since the time of those two cases. Rather, in most of the appraisal cases in Japan, the Court finds that the deal increases the corporate value and the deal process is fair, and hence, decides the synergy value by using the deal price.⁹⁶

In Delaware, on the one hand, such a framework of the fair value depending on the fairness of the deal process has not been adopted as a general doctrine, but, rather, has been criticised by the Court for improperly transferring the responsibility for determining the fair value from courts to private parties.⁹⁷ On the other hand, the Delaware court also emphasised that when the deal procedure is fair, respecting the deal price is required. It held that it does not intend to ignore the economic reality that robust market checks are often the most credible evidence of the fair value; and that it is hazardous to criticise, with hindsight, the prices obtained based on the collective wisdom of many sophisticated parties with real stakes in the market.⁹⁸ Furthermore, in Dell's MBO case, the Delaware Supreme Court held that the Court should respect the deal price in the appraisal case because the parties took many measures to minimise the conflicts of interest and allowed the shareholders to receive the highest possible price.⁹⁹ This line of thought appears to have the same meaning as that of the Japanese case law.¹⁰⁰

In Delaware, the Supreme Court does not clarify the detailed conditions to evaluate the deal process as fair.¹⁰¹ However, one of the most important factors is whether the deal negotiator conducts a robust market check to investigate other potential buyers’ possible offers. For example, in Jarden, the Court of Chancery held that the deal process was not fair. One of the reasons for this decision was the lack of a pre-signing or post-signing market check, and the deal price was not used to determine fair value.¹⁰²

From the viewpoint of comparison between Japan and Delaware, the hurdles of procedural fairness required by Japanese precedents are lower. The Japanese courts tend to treat the deal process as fair and merger price as fair value irrespective of whether the market check is conducted.¹⁰³ The Japanese courts treat the deal process as fair if (i) the target board of directors retains the legal advisors, (ii) the merger price is within the range of the valuation report submitted by the financial advisors or the experts on the valuation of stocks, (iii) in the cases of two-step mergers, the first-step tender offer price is the same as the price of the second step transaction, and (iv) in the cases of interested deals, such as freeze-outs and MBOs, the target board establishes the special committee and receives its opinion stating that the merger price is fair.¹⁰⁴

The Japanese courts have not required the special committee to have the power either to retain its own legal advisors and financial advisors or to negotiate the deal with the power to say no. Moreover, under the Japanese mergers and acquisitions (M&A) practice, there is rarely a competing offer. Given this market reality, a market check could be one of the best practices to deal with any conflicts of interest. Nevertheless, the Court does not demand it. The lack of the pre-signing or post-signing robust market check does not make the Court evaluate the deal process as unfair. Someone familiar with the Japanese M&A practice might oppose this argument and argue that such a market check is unnecessary because strong deal protection is not used in Japanese M&A practice. However, it is challenging for the other potential buyers to launch a competing offer, which generally becomes a hostile offer and faces many objections from the target company, even if strong deal protection is not used.¹⁰⁵

The same is true even when the controlling shareholder is involved. The Japanese Supreme Court, in the Jupiter Telecom case, mentioned that getting an opinion from the special committee and experts is necessary to treat the deal process as fair but did not mention whether the special committee is required to have the power to make negotiations or conduct a market check.¹⁰⁶ One can criticise this holding because even the special committee could end up rubber-stamping the controlling shareholder's offer, given that the controlling shareholder controls the target company and that the special committee does not have the power to negotiate the deal price, reject the deal itself, or search for other potential buyers.¹⁰⁷

Of course, if a target company has a controlling shareholder who is also a buyer, it is highly unlikely that any potential buyer will make an offer because the controlling shareholder will reject it. However, theoretically speaking, the Court in the Jupiter Telecom could have required the board of the target company or its special committee to seek guarantees from the controlling shareholders that they will support a higher bid if it appears and use those guarantees to attract potential buyers to treat the deal process as fair. This theoretical way of thinking is real in Delaware. In the Golden Telecom case, the Court of Chancery of Delaware held that the special committee failed to seek such guarantees from the two largest shareholders of the target company and rejected to deem the deal price as fair value.¹⁰⁸ Furthermore, in the Dell's MBO case, Mr. Dell, who is the founder and CEO of the target company, the shareholder with 15% of shares, and the buyer who offered the MBO, entered into confidentiality agreements with the special committee that required Mr Dell to ‘“explore in good faith the possibility of working with any such potential counterparty or financing source if requested by the Committee,” a provision designed to prevent his prior involvement with KKR and Silver Lake from deterring other possible bidders.’¹⁰⁹

In sum, including the synergy value in the fair value does not greatly change the minority shareholders’ protection in Japan. The conditions based on which the deal process is deemed fair are easy to satisfy because they constitute common practice in Japan and are lenient compared to the Delaware case laws. Of course, under the synergy value concept, the petitioner of the appraisal remedy does not have to worry about losing money by exercising the appraisal right. However, if the Court tends to determine the fair value as the deal price, the petitioner's economic situation by exercising the appraisal right is almost the same as the situation where the shareholder sells their stock in the stock market.¹¹⁰ Thus, it does not make much sense to make the petitioner free from such a concern of losing money by exercising their appraisal right. It gives no real protection to minority shareholders. This attitude of the Japanese courts is inconsistent with what was expected when the appraisal right was revised in 2005.

It is possible in the future for the Japanese courts to scrutinise procedural fairness more stringently. The recent ‘Fair M&A Guidelines’¹¹¹ published by Japan's Ministry of Economy, Trade and Industry on June 28, 2019 might be the potential reform source. Although the Guidelines do not have any legally binding power, they encourage, as best practices, forming a special committee to substantially participate in the negotiation, conducting a market check if appropriate, and using a majority-of-minority condition if appropriate.¹¹² However, there has been no precedent since the publication of the Guidelines. We must wait and see in the future if the Guidelines will change the courts’ attitude in appraisal cases.

Analysis

2005 Amendment and synergy value

Logically, it seems that the Japanese Supreme Court was able to require the ideal procedure even if it is not generally shared in the M&A practice. For example, there was the option for the Court to require that, if there is a conflict of interest, the special committee by an independent outside director must have the authority to appoint financial and legal advisors on its own. Furthermore, the special committee could be required to carry out robust market checks and rigorous negotiations; if the special committee considers the deal inappropriate, it must have the authority to stop it.¹¹³

However, such measures did not seem familiar in Japanese M&A practices at the time of these cases, and neither did the Supreme Court of Japan require such measures. The Supreme Court's criteria at the lower hurdle can be understood as being practically reasonable. This line of explanation might offer a reason for the Supreme Court's doctrine.¹¹⁴

This attitude of the Japanese courts is not consistent with what was expected when the appraisal right was revised in 2005 to enhance the protection of the minority shareholders by allowing synergy to be distributed to minority shareholders, especially in the M&A deal between controlling and subsidiary companies. Its purpose should have been to strengthen the protection of the minority shareholders¹¹⁵ but not to acknowledge the common M&A practice that is taking place. In this respect, the development of Japanese case law seems to have taken a different path from what was expected of the 2005 revision.¹¹⁶

However, it is unfair to criticise the Court for giving up its responsibility. Originally, the problem was with the 2005 revision aimed at protecting both the hypothetical and synergy values. The distribution of increased enterprise value is a matter of surplus distribution arising from transactions. In the case of transactions between independent parties, it is a task of nature that the freedom of transactions must rule and that the Court should not intervene.¹¹⁷ Thus, the cases in which the Court intervenes should be limited to those where an unfair transaction is carried out.¹¹⁸ Avoiding false-positives could justify the Japanese precedents for setting a lower review standard for the deal process's fairness. Thus, requiring the courts to calculate the fair value as hypothetical or synergy value and rigorously intervene in the deal price is asking for too much.

In contrast, the meaning of fair value in the Delaware law is to calculate the fair value by deducting the synergy effects from the actual transaction price. As for the synergies, they are based on a policy that stands opposite to that in the Japanese law. Delaware courts must explore the intrinsic value of stocks, assuming that there had been no merger. The actual deal price is trustworthy for the evidence of such intrinsic value if the control market functions effectively. Therefore, a robust market check is required in Delaware to adopt the deal price as the fair value. Since the Delaware law keeps away from the issue of the distribution of the synergy effects, it is not necessary to argue in what kind of cases the Court should not intervene in the distribution of the synergies.¹¹⁹

Appraisal right as a screening mechanism

The Japanese courts’ attitude would be reasonable from the perspective of efficiency, given that fair value means hypothetical value or synergy value. If the Court determines the fair value by using the deal price, the excessive incentive to exercise an appraisal right can be mitigated by a lax review of the deal process. The above-stated framework of the fair value of the appraisal right under the Companies Act gives dissenting shareholders a no-lose situation. If the dissenting shareholders exercise the appraisal right, they will receive a fair value equal to the deal price or more. The fair value would be equal to or higher than the deal price in the following three possible situations. First, if the merger is a value-decreasing one, the fair value is the hypothetical value higher than the deal price. Second, if the merger is a value-increasing one and the merger process is fair, the fair value is the synergy value that equals the deal price. Third, if the merger is a value-increasing one and the merger process is unfair, the fair value is the synergy value that is higher than the deal price. Thus, considering the Japanese Court's doctrine of the appraisal remedy described above, the shareholders’ incentive to file an appraisal could be excessive.¹²⁰

This excessive incentive for shareholders to file an appraisal would deter not only inefficient mergers but also some of the efficient mergers. In theory, an appraisal right can perform a screening mechanism.¹²¹ From the view of efficiency, such a screening mechanism should deter value-decreasing mergers but should not deter value-increasing ones. Deterring value-decreasing mergers, especially with conflicts of interest, such as MBOs and freeze-outs, might be important in Japan,¹²² where the fiduciary duties of both the controlling shareholders and director are unclear. However, the appraisal remedy whose ‘fair value’ includes the synergy value deters value-increasing mergers more than the appraisal remedy whose ‘fair value’ precludes the synergy value and includes only the hypothetical value. As the Companies Act provides that the resolution of approving mergers shall be a special resolution in which at least two-thirds of the shareholders vote, mergers will not be approved if more than one-third of the shareholders vote ‘no’.¹²³ Alternatively, the parties might not enter into the merger agreement from the beginning out of fear of cash flowing from the company due to the abounding exercises of the appraisal right.

Of course, the above-stated thinking is hypothetical and could be different from that in the real world. For example, the cost of filing an appraisal might be large enough to deter shareholders from filing it. If this is the case, we need not worry about deterring too many value-increasing mergers.¹²⁴ However, because, in an appraisal proceeding, the filing shareholder does not owe the burden of proof to establish ‘fair value,’ the cost of filing an appraisal might not be so high. In several appraisal proceedings whose judgments were published, individual shareholders filed the appraisal proceedings by themselves without hiring attorneys.¹²⁵ Thus, the cost of filing an appraisal is not prohibitively high, at least for some shareholders.

Considering the above analyses, the courts’ attitude to avoid intervening in the deal price lowers the expected value of fair value. It moderates the excessive incentive for shareholders to vote against the deal and exercise the appraisal remedy. This function would be desirable for, at least, value-increasing deals. The aggressive intervention of the fair deal due to the judge's misunderstanding of the M&A practice would motivate minority shareholders to exercise the appraisal right excessively and would be worse than the current courts’ passive review of the deal.

Conclusion

Japanese legislators expected the appraisal right to work as a form of discipline on an M&A, especially in the case of an M&A with conflicts of interest. However, the Japanese courts are reluctant to intervene in the deal price by holding that the deal process was not fair enough to respect the deal price. Instead, the Court tends to treat the process that the M&A practice generally takes as fair. The establishment of the Court's framework to inquire whether the deal procedure was generally accepted as fair reduces the attractiveness of the appraisal right. Although the dissenting shareholder theoretically has the chance to get a higher synergy value than the deal price, such a framework makes it very unlikely to have such a chance.

Whether the current situation is desirable for Japanese M&A markets is unclear. On the one hand, limiting the Court's intervention through the appraisal right is efficient, especially considering the arms’ length deal. Assuming a world where shareholders like hedge funds exercise the appraisal right and claim billions of yen, the Court's aggressive intervention of the fair value would have a chilling effect on M&A deals. This is true in Japan because the shareholders who exercise their appraisal right are in a no-lose position. In terms of game theory, it is a weakly dominant strategy to exercise the appraisal right if the cost of exercising it can be ignored. As the concept of fair value could make the incentive to exercise the appraisal right excessive, limiting the number of cases where the Court determines a price higher than the deal price to very few would strike the right balance.

On the other hand, if we expect a policy to strengthen regulations on the issue of conflicts of interest, the current situation is not desirable. The Court sets too low a standard for dealing with such an issue. If we expect the appraisal right to be a useful tool to regulate the conflicts of interest in Japan, we should reconsider the 2005 reform and change the concept of fair value regarding how synergy must be incorporated in the appraisal right.¹²⁶ Such a change will eliminate the need for consideration to constrain the Court's intervention in the surplus of the deals. In other words, to protect the interests of shareholders, it is not always good to strengthen the rights of shareholders; rather, by restricting the rights of shareholders a little more than in the current situation, it is possible to strengthen the protection of the interests of shareholders instead.

If we need to keep using the fair value concept using both hypothetical and synergy values, then other routes would be necessary. For example, clarifying the fiduciary duties regarding M&A would help strengthen the protection of the minority shareholders. In Delaware, the basic method to protect minority shareholders has been fiduciary duties, such as the Revlon¹²⁷ standard and the entire fairness¹²⁸ standard. The attention on the appraisal right in Delaware is relatively new compared to that on fiduciary duties.¹²⁹ Thus, if the other routes clarify what process constitutes a fair deal in Japan, the courts in the appraisal litigation will be able to rely upon such ideas without creating rules of what a fair deal is from scratch. The Fair M&A Guidelines might be helpful in this regard. We must wait and see in the future if this guideline changes the courts’ attitude in the appraisal cases.