Cautious Optimism for Equity Markets in Japan

Financial news from Japan has been predominately grim for the past two decades, and the interest of global investors has shifted to China and other emerging markets.

Yet, things may not be as dire as they seem.  Despite recent travails, Japan is still a leading industrial country with a considerable number of profitable and innovative companies and offers unique investment opportunities for astute and patient foreign investors.  What has not always matched the quality of the investment opportunities is the legal and regulatory framework within which investment transactions are carried out.  Since the bursting of the economic "bubble" of the late 1980s, Japan has been plagued with relatively weak equity capital markets, a declining share of global equity capital market capitalization, declining trading volumes, embarrassing technical glitches in trading on the Tokyo Stock Exchange (TSE) and assorted accounting and insider trading scandals.  Yet recently there have been some important, if tentative, signs that a new environment is emerging, which may help the equity markets in Japan correct their 20 year drift and improve integration with the rest of the world's financial markets.

Nexon IPO

On December 14, 2011, Tokyo based online gaming firm Nexon went public on the TSE with a $1.2 billion IPO, which received widespread coverage in the global financial press.  The Nexon IPO was the largest in Japan in 2011 and was the second largest technology/Internet IPO globally in 2011 trailing only Russian search engine Yandex NV's $1.4 billion IPO on NASDAQ in May 2011 and edging out US online game maker, Zygna, which raised $1 billion through a NASDAQ IPO on December 16, 2011.  Much of the press coverage of the Nexon offering related to the immediate fall in its share price in what were clearly choppy markets not only in Japan, but in Hong Kong and the US as well.  What was not highlighted in the press coverage of Nexon was the unique nature of the company.  Nexon was founded in South Korea and the majority of its 3,240 employees are still based in South Korea.  The company derives most of its revenue from South Korea (35%), followed by China (30%) and Japan (18%).  That a largely South Korean Internet gaming enterprise with its largest markets in China and South Korea would not only go public on the TSE, but be the largest IPO of the year in Japan would have been almost unheard of 10 to 15 years ago.

What are the factors that led up to this situation?  It is beyond the scope of this article to examine all of the factors and conditions that led to Nexon relocating to Japan and going public on the TSE, but it can be argued that some of the profound changes in Japanese corporate law and capital market regulation, that have gone relatively unnoticed outside of Japan, may have contributed to a more conducive environment for a company like Nexon.

As a result of the "lost decade," over the last 10 to 15 years there has been a fundamental change in many of the laws, rules and incentives faced by Japanese companies.  A change that may have relevance to Nexon's situation was the streamlining of the process for new company formation and capitalization that occurred with the adoption of the Companies Act in 2005.  The Companies Act essentially replaced the archaic Commercial Code, which was enacted in 1890.  One of the more noticeable changes for the broader market has been with respect to the ownership structure of public companies.  Many of the previous cross-shareholders - banks and affiliate companies - have been replaced by institutional and foreign investors, who together own approximately 50% of the market capitalization of companies traded on the TSE.  This change has resulted in increased opportunities for shareholder activism, although to date the tangible results of this activism have been difficult to measure.  There has been other considerable change in the area of corporate law with, for example, new provisions for minority squeeze outs and second step mergers - making it possible, in theory, to acquire control of a public company.  In the accounting area, efforts have been under way to bring Japanese accounting standards into line with international standards, specifically, International Financial Reporting Standards (IFRS).  However, as a result of the March 11, 2011 earthquake and related calamities, the adoption of IFRS by Japanese companies has been put on hold.  Despite this setback, other accounting changes have been implemented, including the introduction of audited consolidated financial statements, which has helped improve financial transparency.

TSE/Osaka Securities Exchange Merger

Another interesting development was the November 14, 2011 announcement of the merger between the TSE and the Osaka Securities Exchange.  The combined entity will be the third largest securities exchange globally in terms of market capitalization, after NYSE Euronext and NASDAQ OMX.  The consolidation of national exchanges is long overdue and should help improve the efficiency and global competitiveness of Japan's equity markets.  The short term benefits of the merger are likely to be more operational in nature.  Long term benefits, such as the development of a globally competitive financial market, will probably only be realized if the combined exchange is serious about improving access and attractiveness for foreign investors.  Steps that can be taken in that regard include increasing the use of English for listed company disclosure and trading activities, integrating with other financial markets in Asia, such as Singapore and improving the financial transparency of listed companies.

M&A Disclosure

A less tangible development occurred on December 16, 2011, with the Japan Financial Services Agency announcing that it would work with the TSE and other exchanges to review existing regulations to improve disclosure about M&A transactions for listed companies.  The announcement comes after the discovery in October 2011 of at least $1 billion in financial and accounting irregularities arising out of M&A transactions at TSE listed Olympus Corp. over a 13 year period.  This is an admittedly forced and small step by Japan's primary financial regulator and no details about the timing or nature of any new regulation were provided at the time of the announcement.  There is no assurance that any revolutionary disclosure regime will be implemented, but at a minimum this signal from the regulators should provide a small boost to investor confidence in Japan's equity markets.

The above, taken individually, may not appear to be radical or much of a change to most observers outside Japan.  Viewed together however, an argument can be made for cautious optimism regarding positive incremental change in the some of the underlying institutions, practices and mindsets that have had a stranglehold on Japan's equity markets for the past 20 years.

Piyasena C. Perera is Senior Foreign Counsel (Gaikokuho Jimu Bengoshi) at Anderson Mori & Tomotsune, one of the leading full service corporate law firms in Japan (www.amt-law.com).  Mr. Perera has extensive experience in all areas of corporate finance, including banking, corporate/M&A, debt and equity capital markets, real estate finance and regulatory advice, with an emphasis on cross-border transactions across a number of geographies, principally the US, China, Japan, India and UK/Europe.  Mr. Perera can be contacted by telephone at: +81 (0)3 6888-1292 and by email at: piya.perera@amt-law.com.