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Aiming for Better Equity Financing

Aiming for Better Equity Financing

Equity financing

Equity financing is an important managerial option that involves issuing new shares to increase shareholders’ equity in the company and obtain funding to be channeled into growing the business and enhancing corporate value1.

In Japan today, the most common methods of equity financing are public offerings, third party allotments, and rights offerings. A public offering is a way to offer equities, such as new shares, to the general public through underwriting broker-dealers, and a third-party allotment is a way to issue equities directly to designated investors or shareholders. In a rights offering, a company makes a gratis allotment of warrants to existing shareholders, and the warrants are listed on a stock exchange.

Issues to be addressed

In recent years, some cases of equity financing that could potentially undermine the interests of shareholders and investors have emerged.

Firstly, amid the prolonged slump in the stock market, since 2009, many listed companies have issued new shares through public offerings that have led to large-scale dilutions, and some cases were subject to criticism for damaging the interests of existing shareholders.

Secondly, third-party allotments inevitably bring about concerns related to the dilution of shareholders’ voting rights and company management influencing the composition of its major shareholders. To address these potential issues, Tokyo Stock Exchange (TSE) developed listing rules with respect to third-party allotments in August 2009.2 However, cases that seemed to circumvent the spirit of the rules continued to be sporadically observed. In some cases, third-party allotments were abused as a means for “unfair financing,” which consists of improper conduct both in the issuing process and in the secondary markets.

Lastly, rights offerings have increased since 2013, but most of them have been so-called non-commitment type, where the financing does not go through the due diligence process by underwriters. This includes cases where listed companies, unable to raise capital through public offerings or third-party allotments due to deteriorating business performance, seemed to use this scheme as a last resort. Also, there have been cases where the rationality of the allocation of raised capital was doubtful. There is criticism against these cases that the raised capital has not been effectively used to enhance corporate value.

  • Corporate value is enhanced through developing robust and sustainable earnings power that is generated by providing quality goods and services to meet social demand. In order to realize this, a company should pay attention to the sustainable earnings power guided by mid- and long-term perspectives and to the maintenance of good relationships with various stakeholders, including shareholders, business partners, employees, lenders, and the larger social community. These points are also consistent with the enhancement of corporate value from the viewpoint of the existing and potential shareholders of the company.
  • The new listing rules include the revised criteria to delist a company when it carries out a third-party allotment with above 300% dilution (excluding cases that TSE deems it unlikely to undermine the interests of shareholders and investors), and the introduction of a rule in the Code of Corporate Conduct that requires a company to follow certain procedures to convince shareholders when carrying out a third-party allotment with 25% or above dilution.

Principles-based approach

A rules-based approach is crucial for resolving and instilling discipline in these issues relating to equity financing. Clearly-stipulated rules are essential for improving the transparency and predictability of regulatory oversight in a capital market that is open to the general public. On the other hand, there are also issues such as regulatory loopholes, the need to keep the rules up-to-date with new financial instruments or trading methods, and substantially unfair transactions being justified by superficial regulatory compliance. As for equity financing, we sometimes see deals intended to profit from unfair gains in the capital market through schemes composed of transactions that are apparently not in direct violation of laws, regulations, and exchange rules.

Introducing the principles-based approach on top of the rules-based approach shall effectively function to cope with the issues mentioned above. The principles-based approach is aimed at having listed companies and market professionals fully recognize and share important common values and behavioral standards represented by a set of guiding principles, so that market participants behave themselves in accordance with them, thereby improving the overall quality of the market.

If a common understanding of the principles is widely shared and the examples of equity financing based on the principles become more prevalent, they will turn into common market practices. As a result, a sense of the norm will develop among listed companies and market professionals, and the principles will be instrumental in fostering a system of decentralized discipline. Consequently, the principles-based approach will complement the weaknesses of the rules-based approach stated above and contribute to enhancing the quality of the entire capital market.

Intended Effect of the Principles

A common understanding of the principles among listed companies and market professionals is expected to bring about the following effects.

  1. For listed companies, the principles will clarify the fundamental concepts and desired approach toward equity financing to serve as a guide for managerial decisions even in the absence of clear rules or established interpretations.
  2. For parties providing advice to listed companies, such as underwriters, broker-dealers, lawyers, CPAs, and consultants, they will be able to provide guidance to listed companies, on the basis of a firm understanding of the principles, to prevent deviation from the fundamental concepts, and thereby contribute to appropriate managerial decisions.
  3. For shareholders and investors, the principles can form the basis for making rational investment decisions by providing the grounds for assessing the appropriateness of equity financing by a listed company.
  4. For securities exchanges, the principles serve as guidelines in their communications with listed companies and market professionals in the course of conducting self-regulatory operations. The fundamental concepts also form guiding standards to facilitate appropriate responses to cases where directly applicable rules cannot be identified, or the interpretation or application of a comprehensive clause is considered.

Unlike laws, regulations, and exchange rules, the principles do not directly restrict the activities of listed companies and market participants. Therefore, without a regulatory basis, sanctions will not be imposed on a listed company even if it does not fully comply with the principles.

The Principles for Equity Financing

Introduction

Equity financing contributes to the business development of a listed company by supplying additional capital, and facilitating appropriate and smooth equity financing is one of the necessary traits of an excellent capital market.

Japan Exchange Regulation (JPX-R), as a self-regulatory organization tasked with the mission of ensuring reliable and fair capital markets, sets forth the following principles to be observed for encouraging and facilitating high-quality equity financing. JPX-R strongly hopes that a common understanding and utilization of the principles will prevail among shareholders and investors as well as listed companies and market professionals including broker-dealers, lawyers, CPAs, and consultants.

Principles for Equity Financing

Equity financing shall

  1. Contribute to improving corporate value.
    It is rationally expected that the raised capital will be effectively utilized and will contribute to better profitability of the issuing company based on the stated purpose of raising funds, plan for the allocation of raised funds, past achievements of raised funds, and business performance forecast.
    In addition, the company’s business results, financial status, and management performance shall not lead to doubts over the abovementioned prospects.
    After conducting equity financing, the company can be expected to improve corporate value in a sustainable manner3 through sound management.
  2. Not unfairly damage existing shareholders’ interests.
    The scheme, timing, and terms and conditions of the equity financing shall sufficiently consider the degree of dilution to existing shareholdings and the impact on the secondary market, and existing shareholders shall be provided with an adequate explanation of the rationale.
  3. Not be detrimental to trust and fairness in the market.
    Entities that seek to obtain gains by unfair methods and their collaborators shall be prevented from participating in the capital market.
    Equity financing scheme shall not be designed to obtain unfair gains through a combination of individual transactions that do not immediately constitute a violation of rules, regulations, and exchange rules.
  4. Be transparent with timely and appropriate disclosure of information.
    Disclosure shall be conducted with appropriate timing and shall consist of contents that are true and consistent, cover sufficient scope, and present understandable and concrete explanations, so as to provide shareholders and investors with useful information for making investment decisions.
    After conducting equity financing, the issuing company shall be able to justify that the disclosed contents at the time of issuance were appropriate.

DISCLAIMER

DISCLAIMER: This translation may be used for reference purposes only. This English version is not an official translation of the original Japanese version. Certain parts of the translation may have been edited to accommodate differences in writing style and expression between English and Japanese. In cases where any differences including, but not limited to, those differences above occur between the English version and the original Japanese version, the Japanese version shall prevail. This translation is subject to change without notice. Tokyo Stock Exchange, Inc., Japan Exchange Regulation, Japan Exchange Group, Inc., and/or their affiliates shall individually or jointly accept no responsibility or liability for damage or loss caused by any error, inaccuracy, misunderstanding, or changes with regard to this translation.