Question 1 The Japanese corporate governance system differs vastly from the US system. Discuss corporate governance issues that may arise under the Japanese keiretsu. The corporate governance system in Japan is widely different from the US one insofar as it mostly involves a unique business model called “Keiretsu”. A Keiretsu is a form of corporate structure that groups a set of companies with interlocking board of directors and common business interests. Thus, due to its particular structure, some governance problem may arise under this Japanese Keiretsu: a) Issues from the perspectives of financiers
Because the business is considered almost like an extended family, the financing may become political and the Japanese Keiretsu will almost always give favor to members of their Keiretsu. This could lead the financiers, for instance, to finance a company member of their Keiratsu they wouldn’t have finance otherwise. As far as the potential financiers are concerned, the main issue is the difficulty to enter and invest in the Keiretsu. Getting financial information about the Keiretsu firms could be complicated insofar as the financial and accounting statements are not disclosed.
Thus, such discretion could lead to an ambiguity or a lack of understanding from an outside perspective. Actually, the keiretsu are just trying to protect themselves from what they fear the most that is to say the yakuza and the greenmailing. b) Issues from the perspectives owners As mentioned above, the keiretsu are suspicious towards the “outside” and this behavior may make foreign owners face some difficulties. Because the keiretsu system is much more in favor of inside shareholders than the outside ones, the former may find some difficulties to make the most of their shareholder rights.
And this can maybe explain why the outside shareholders are often a minority in comparison with the shareholders of the keiretsu. Moreover, even if one of the outside owners becomes the biggest one, as T. Boone Pickens did, he may not be able to use his rights as he hoped. c) Issues from the perspectives suppliers One of the main issues for external suppliers is to the relationship between OEMs and suppliers that often leads to dumping on the prices and enables the outside supplier to compete with such cheap prices.
As far as the integrated suppliers are concerned, the exclusive partnership with the keiretsu they belong enables them to do business with another leading firm and to gain market shares. d) Issues from the perspectives employees On the one hand and in case of horizontal integration, the very structure of a Keiretsu can lead into a confusion in management. The management transfers are so frequent that employees do not understand for which company they really work for is. One the other, the strong stability that comes out from this system could lead to a lack of action and performance from employees.
What were T. Boone Pickens’ motives when he bought the share? In the eyes of many, Mr. Pickens was only acting as a front man for Mr. Watanabe, a well-known green mailer in order to pave a way to gain power and control over the corporation. Mr. Pickens denies all these accusations of greenmailing by claiming that he bought the share to carry out a “test case” in order to evaluate the accessibility of the market. In others words, his initiative has the only aim of checking whether the United States could make, in the future, profitable investments in Japan depending of the degree of welcome of the market.
Moreover, it is not implausible to think that one motive of T. Boone Pickens was the quest of profit. It should be borne in mind T. Boone Pickens targeted Koito as an undervalued investment opportunity in so far as he anticipated a Koito stock rise due to the tight link between Toyota and Koito. The good performances of Koito stock combined with the rise of the net income and sales reinforce this idea due to the fact that the shareholder’s average annual return has impressively increased. So the pursuit of rise of the dividends could have motivated him to buy the share.
As the largest shareholder of Koito Manufacturing, is he entitled to representation on the board, does Japanese law allow for that? If not what in the law could he use to get an equivalent result? With 26. 4% of stock, T. Boone Pickens should have been entitled to representation on the board of Koito insofar as the Japanese law gives him rights due to the fact that he owns more than 10% of stock. But not so in the Japanese Keiretsu point of view. He was overwhelmingly denied board access in a 1989 annual meeting.
“…It is not a custom in Japan just to say, ‘I’ve become a major shareholder so I should become director. ’”, said Takao Matsuura, president Koito Manufacturing Ltd. There are reasons to wager that his seat on the board was compromised by the fact that the company considers him as a greenmailer. Knowing that T. Boone Pickens was planning to increase his stake to 30%, he could obtain board representation by acquiring 4% more than what he expected. In fact, the Japanese law states that those with at least 34% ownership could propose special shareholder resolutions.
An alternative would be to establish a new relationship between Mr. Pickens and all the members of the keiretsu based on loyalty and transparency. They would not suspect him of greenmail anymore. We can suppose that T. Boone Pickens has chosen this way insofar as he supported the adoption of a proposal prohibiting Koito from paying greenmail. Question 3 Besides board representation, T. Boone Pickens demanded higher dividend payouts. Were his demands justified? Provide quantitative evidence to back your answer. Besides board representation, T.
Boone Pickens asked for higher dividend payout saying that “Boone Co’s philosophy was to put stockholder interests first” (page 7) and in this very case, his demand for a higher dividend can be justified. Indeed, when we look at the dividend payout ratio for the period 1982 – 1985 (Table 1), it decreases meanwhile the retained earnings was increasing (Table 2). Moreover, at the same period, the proportion of cash was also increasing. In others words, the retained earnings were not invested enough and stay as cash.
Then in 1986, we noticed that the payout ratio increased up to 39% and at the same time the retained earnings and the cash goes strongly down. Finally, almost the same phenomenon is observed between 1988 and 1990. In other words, the payout ratio is not positively correlated to the retained earnings which are not invested and stay as cash. Table 1 Table 2 Is there anything in the Japanese commercial code that would allow Pickens to try to get more dividends? If yes, why doesn’t he use this? If not, based on your experience as an international investment banker, what changes would you recommend him to propose?
In order to increase dividends, T. Boone Pickens had several solutions. Indeed, many researches on the conflicts of interest between majority and minority shareholders show that dividend payout is negatively related to ownership concentration and support the assumption that large shareholders do not appear to use dividend policy to remove excess cash. In other words, firms with concentrated ownership are less likely to increase dividends when profitability increases and more likely to omit dividends when investment opportunities improve. So, T. Boone Pickens could decrease the ownership concentration of Koito.
There are also some more aggressive solutions to get more dividends. T. Boone Pickens could increase his shares ownership in order to increase his decision power in the General Assembly insofar as “a owner of 34% or more of the outstanding stock could propose special shareholder resolutions”. Question 4 Pickens accused Toyota of limiting profits earned by Koito Manufacturing. Explain how the mechanism works? This mechanism is related to the very structure of keiretsu insofar as Toyota, like most Japanese OEM, owns equity positions in its suppliers.
In 1986 almost half of Koito’s output was bought by Toyota and at the same time, Toyota has built a dominant position over Koito by having a 19%-part of Koito’s ownership. Therefore, Toyota was not just one of Koito’s customers but also one of its owners. Through its powerful influence and thanks to the close and informal relationship between Toyota and its suppliers, the car manufacturer had been able to negotiate supply contracts, lower prices and then limited profits earned by Koito. Is this a self-dealing transaction?
According to Steven L. Emanuel (“Corporations”, 2009), a self-dealing transaction occurs when three following conditions are met : (1) A key player (officer, director or controlling shareholder) and the corporation are on opposite sides of a transaction, (2) The key player has helped influence the corporation’s decision to enter the transaction (3) The key player’s personal financial interests are at least potentially in conflict with the financial interests of the corporation. In the case of Koito, 3 members out of 23 are Toyota’s executives.
Even if these 3 members are no longer Toyota’s executives, the Japanese notion of loyalty and the business relations between Toyota and Koito (Toyota buy 48% of Koito’s output) could imply that these three chairmen could act in favor of Toyota or at least try to satisfy the two companies. And in this way, the supplier was treated unfairly and conflicts of interests might have occurred. If Pickens gets access to financial information, how can he set out to prove his accusations? If you were an investment banker, what accounts or data would you tell him to scrutinize.
If Pickens gets access to financial information, he could analyze the Income Statement and compare the evolution of the growth of sales and the growth of gross profit over these past years. Generally, sales and gross profit evolve in the same direction unless there is a below cost-selling. However, here we noticed for example that in 1986, as sales had grown by almost 10,2%, gross profit had grown by 7% and that in 1990, when the sales had grown by 10. 85%, gross profit had only grown up by 2. 8%. Such comparisons could be setting off alarm bells and could point out the fact that Toyota is limiting profits earned by Koito Manufacturing.
On the other hand and if he can, he could also compare directly the price of goods sold to Toyota with the price of the same goods sold to minor customers such as Hino Motors. A high difference between the two prices combined with the fact that three directors of Koito are retired Toyota executives, would prove these “self dealing transactions”. Would you suggest to change the charter of the organization of Koito? As investment banker, I would suggest him to analyze thoroughly the income statements and the supply contracts between Toyota and Koito in details to reinforce his accusations.
As far as the charter of the organization of Koito is concerned, I would suggest to add a clause which enables a person somehow related to a strong customer or a strong supplier to be appointed as director to Koito’s board of directors. Question 5 Toyota has threatened to cut all ties with Koito Manufacturing if Pickens take over the company. How would this affect Pickens investments? If you were a minority shareholder in Koito Manufacturing, whose side would you take? Calculate the value of your shares with or without Toyota.
Because Toyota is the second largest shareholder in Koito and is its principal customer, representing 48% of the total sales (Exhibit 2), we may think that cutting ties with Koito Manufacturing will lead to huge losses, at least in the first year. Let’s then calculate the value of a share with and without Toyota. In order to use the Discounted Cash Flow methodology, here are the assumptions we made : * The value of the firm is equal to the value of the discounted cash flows for the next four years plus it’s terminal value.
* The same growth is expected for the coming four years (this growth was calculated as the mean of the previous years growth) * Because the lack of information concerning the cost of equity we used today Koito’s beta (1. 38), a risk free rate of 3% and a Rm of 10% (return on S&P) in order to calculate an approximative WACC. Our calculations provide us with a WACC of almost 8%. With Toyota : Without Toyota : If I were a minority shareholder I would probably take Pickens’ side because he puts shareholder interests first.
However, I would be careful and make sure that making stockholders’ interest first instead of company’s one will not damage the entity’s wealth. Based on your assessment of the case, are large shareholders an effective solution to corporate gouvernance problem? Based on the analysis of this case, it appears that being a large shareholder is not necessarily an effective solution to the corporate governance problem. Indeed, even if T. Boone Pickens is the largest shareholder, he actually has no influence on “management issues” including those which concern the amount of dividends paid.