The new corporate law introduced in Japan last year has created a more favourable legal environment for foreign investors. Tim Lester reports

For a country once renowned for its difficult legal and regulatory environment for foreign business, Japan has come a long way and now presents a more attractive and business-friendly market to foreign investors. But how does this change play out in current Japanese business practice? Are Japanese corporates losing out in the international market by holding on to their traditional values and the Japanese management preference for consensus over conflict?

From a post-war standpoint of heavy restrictions on foreign investment in Japan, there has been a wave of significant legislative and regulatory changes and initiatives over the last 10 to 12 years aimed at deregulating the Japanese market and making it a more attractive environment for foreign investment. Most recently, new measures by the Government to encourage M&A and foreign investment were introduced by former Prime Minister Koizumi as Japan came under increasing pressure to modernise its corporate framework as well as being prompted by a desire to close the widening gap between Japan and China, whose explosive growth over the last few decades has been fuelled by massive foreign investment.

Japan's new corporate law, enacted in May 2006, is one of these new measures. Although direct mergers between Japanese and foreign companies using the shares of the foreign corporation as consideration for the merger are still not allowed, the Corporate Law introduced provisions permitting 'triangular' mergers (sankaku gappei). These enable Japanese subsidiaries of foreign companies to use shares of their parent to purchase Japanese companies, therefore enabling a foreign company to effectively absorb a Japanese company without using cash. Although there are still certain restrictions, the system was expected to encourage cross-border M&A activity. However, the scheme faced strong opposition from Japanese business groups who feared that they would precipitate a surge in hostile takeovers in Japan by foreign investors that would be damaging to Japan's corporate fabric. As a result of intense lobbying, the law's provisions were therefore delayed from coming into effect until May 2007. This delay gave nervous Japanese companies time to prepare themselves for the anticipated onslaught of hostile takeovers by foreign investors, by planning and implementing takeover defences, such as 'poison pill' defensive measures.

Why was there such immediate and widespread resistance to the new regulations? The Japanese Business Federation argued that Japan's legal system was inadequate to defend companies and shareholders from hostile takeovers that could damage 'corporate Japan' and therefore companies should be given time to prepare for the changing environment. There were also concerns about the potential leakage of technology abroad when big foreign companies swallow small Japanese rivals with great technical expertise. However, many believe that the real reason behind the concern directed at foreign investors was based on entrenched notions of how business should be conducted and managed in Japan. In a country that seeks to avoid open confrontation and promotes a consensual management style, the prospect of foreigners bringing US and UK-style activism to Japanese companies was too worrying a prospect for long-entrenched management boards to bear. In particular, foreign investment funds still seem to be viewed as 'vultures' by many critics of Japan's liberalisation, seeking paper profits at the expense of companies and their workers.

The recent case of Steel Partners v Bull-Dog Sauces seems to show that such attitudes are not limited to such Japanese business management critics. Steel Partners, a New York-based activist hedge fund, has invested heavily in Japan over the past few years, taking stakes in more than 30 companies. Its aggressive approach (from a traditional Japanese perspective), with a string of unsolicited takeover offers, has not proved popular in Japan among certain sections of the business community and its recent takeover attempt of Tokyo-based condiment maker Bull-Dog Sauces showed just how pervasive corporate Japan's unease with such foreign parties remains.

In May, Steel Partners, which had amassed a 10.52% stake in Bull-Dog Sauce, launched an unsolicited tender offer of 1,584 (£6.80) for each of the remaining shares in the company. It raised its bid to 1,700 (£7.29) in June; however, Bull-Dog was poised and ready to thwart its advances. In June, shareholders of Bull-Dog approved a raft of board-proposed measures to fend off Steel Partners, including, most controversially, a new three-for-one stock warrant issue to all shareholders except Steel Partners. This 'poison pill' would dilute Steel Partner's 10.52% stake, which previously made it the company's biggest shareholder, to less than 3%.

Steel Partners immediately sought an injunction against the scheme, which it argued breached the principle of shareholder equality and was discriminatory against them. The case reached Japan's Supreme Court, which upheld the decision of the lower courts and declined to grant the injunction, all but guaranteeing the failure of Steel Partners' takeover pursuit. Perhaps most indicative of the prevailing attitudes was the language used by the Tokyo High Court, which described Steel Partners as a "vulture investor" and "an abusive acquirer which could harm Bull-Dog's enterprise value". The courts denied that the scheme violated principles of equal treatment, stating that "corporate law does not deny discrimination of some shareholders in an economic sense in terms of voting right fluctuations".

Bull-Dog had to pay the price for its victory – installing such anti-takeover measures comes at a cost, not to mention the costs of fighting the legal battle. The company is expected to post a loss of more than 1bn (£4.3m) in the current fiscal year ending in March 2008 due, in part, to the high costs of resisting the takeover. However, it is not alone. More than 300 Japanese companies have adopted or plan to adopt poison pills, while many are increasing cross-shareholdings. The question that remains to be seen is what long-term effects such actions will have on the cross-border M&A market in Japan.

This is unfortunate as foreign investors have shown a keen interest in Japan over the past few years. After the economic bubble burst in 1990, many companies' shares languished for more than a decade and it was in companies such as these that activist investors saw potential value. However, despite investors' best efforts to raise operational and financial efficiency, many Japanese companies have resisted change and continue to have low returns, especially in comparison to international competitors. Could the Supreme Court's latest decision weigh heavily on the anticipated growth of further foreign investment in Japan?

Perhaps somewhat surprisingly, it is the Japanese Government that seems to be worried that it might. On 7 August this year the Cabinet Office released a White Paper warning companies against adopting defensive measures to block unsolicited takeover moves, arguing that such tactics could harm the country's productivity. This unusual example of the Government overtly supporting M&A activity highlights concerns that unless Japan can boost its productivity levels it will not be able to maintain growth. The report points out that companies that have been taken over have generally shown greater improvement in profitability (return on assets) than other companies, three years after being the subject of an M&A transaction.

The M&A market in Japan is still increasing rapidly compared with the stagnation of the 1990s. However, the principal activity is domestic-based. In 2005 there were 2,725 transactions, representing a five-fold increase in M&A transactions over a 10-year period. Increased productivity is crucial if Japan is to continue on its path of sustainable economic growth, and with M&A one of the most effective ways of achieving productivity growth, it is widely considered that foreign investment in Japan will become more important. The courts must therefore strive to find a middle ground which protects companies from truly abusive investors but preserves and truly protects the principles of shareholder equality and value.

What remains to be seen is whether Japanese businesses will be willing to leave traditional attitudes behind and embrace new approaches for the cause of increasing shareholder value and strengthening the Japanese market and 'corporate Japan'.