Acquisition of Treasury Stock by Japanese K.K.s: Purposes, Procedures, and Accounting Treatment

Japanese Attorney at Law - Bengoshi L.L.

• 8 min read

The acquisition and holding of its own shares by a company—commonly referred to as treasury stock or self-shares (jiko kabushiki 自己株式 in Japanese)—is a significant corporate finance activity with various strategic implications. Historically, Japanese corporate law imposed strict restrictions on a Kabushiki Kaisha (K.K., or joint-stock company) acquiring its own shares due to concerns about potential abuses, such as market manipulation, insider trading, or unfair treatment of shareholders. However, recognizing the legitimate business reasons for such acquisitions, the Japanese Companies Act (Kaisha-hō) has progressively liberalized these rules. Today, K.K.s have considerable flexibility to acquire their own shares, provided they adhere to specific procedures and, crucially, the source regulations governing distributions to shareholders. This article explores the purposes, procedures, legal effects, and accounting considerations related to the acquisition of treasury stock by Japanese K.K.s.

The Shift Towards Liberalization and Current Stance

Under older iterations of Japanese commercial law, a company's ability to acquire its own shares was severely limited, generally permissible only in exceptional circumstances (e.g., for share cancellation, in mergers, or when exercising a call option). The primary concerns were:

  • Impairment of Capital: Using company funds to buy back shares could deplete the company's capital, harming creditors.
  • Unfairness to Shareholders: Selective buybacks could favor certain shareholders over others.
  • Market Manipulation/Insider Trading: The company or insiders could manipulate the share price through buybacks.
  • Management Entrenchment: Management could use buybacks to consolidate control.

The current Companies Act, however, reflects a significant shift towards liberalization, acknowledging that share buybacks can serve legitimate corporate purposes. The overarching principle now is that a company can acquire its own shares for any reason, provided it complies with:

  1. Procedural Requirements: Ensuring proper authorization and transparency.
  2. Source Regulations (Distributable Amount): Treating the acquisition as a form of "distribution of surplus," meaning it must be funded from the company's distributable amount (Article 461). This addresses the creditor protection concern by ensuring that share buybacks do not improperly erode the company's capital base needed to satisfy creditor claims.

Purposes for Acquiring Treasury Stock

Japanese K.K.s acquire their own shares for a variety of strategic and financial reasons:

  1. Returning Surplus Cash to Shareholders: When a company has excess cash beyond its operational and investment needs, share buybacks can be an efficient way to return value to shareholders, often as an alternative or supplement to dividends.
  2. Improving Financial Ratios: Reducing the number of outstanding shares can improve earnings per share (EPS) and return on equity (ROE), potentially making the company more attractive to investors.
  3. Signaling Undervaluation: A company might initiate a buyback program if its management believes its shares are undervalued in the market, signaling confidence in its future prospects.
  4. Funding Employee Stock Option Plans or Other Equity Compensation: Acquired treasury stock can be used to satisfy obligations under employee stock option plans or other forms of equity-based compensation, avoiding the need to issue new shares and dilute existing shareholders.
  5. Facilitating Mergers and Acquisitions: Treasury stock can be used as consideration in acquiring other companies (e.g., through a share exchange).
  6. Increasing Shareholder Value in Response to Takeover Bids: While subject to scrutiny to ensure it's not primarily for management entrenchment, buybacks can sometimes be used to increase the share price and make a hostile takeover less attractive.
  7. Adjusting Capital Structure: Buybacks can be part of a broader strategy to optimize the company's capital structure (debt-to-equity ratio).

Procedures for Acquiring Treasury Stock by Agreement with Shareholders

The most common method for a company to acquire its own shares is by agreement with shareholders. The Companies Act (Article 155 and following) details the procedures, which vary slightly depending on whether the company intends to acquire shares from all shareholders proportionally or from specific shareholders.

General Principle: Resolution by Shareholders' Meeting (Article 156, paragraph 1)

As a general rule, for a company to acquire its own shares by agreement with shareholders, it must first obtain approval through an ordinary resolution of a shareholders' meeting. This resolution must specify:

  1. The class and number of shares to be acquired.
  2. The total amount of consideration to be paid for the shares (e.g., total cash amount).
  3. The period during which the shares may be acquired (not exceeding one year).

This shareholders' meeting resolution provides the general authorization for the buyback program. The actual execution of specific acquisitions within these approved parameters is then typically handled by the board of directors (or directors in a company without a board).

Specific Procedures and Exceptions:

  1. Acquisition from All Shareholders Proportionally (Market Purchases, Tender Offers):
    If the company intends to acquire shares from all shareholders on a proportional basis (e.g., through open market purchases on a stock exchange for listed companies, or via a tender offer made to all shareholders), the specific details of the acquisition (e.g., price, exact number within the shareholder-approved limit) are generally determined by the board of directors based on the shareholder resolution (Article 157).
    • For market purchases, the company entrusts a securities firm to buy shares on the exchange.
    • For tender offers (kōkai kaitsuke), specific rules under the Financial Instruments and Exchange Act also apply for listed companies.
  2. Acquisition from Specific Shareholders (Article 158, 160):
    If the company intends to acquire shares from specific shareholders (i.e., not on a generally available, proportional basis), more stringent procedural requirements apply to ensure fairness to other shareholders who are not given the same opportunity to sell:
    • The initial shareholders' meeting resolution authorizing the acquisition must be a special resolution (Article 160, paragraph 1, applying Article 309, paragraph 2, item 2).
    • Shareholders other than those from whom the company proposes to acquire shares have the right to demand that they also be included as sellers in such acquisition (the "right to demand to be added as a seller" - uriwatashi tsuika seikyūken) (Article 160, paragraphs 2 and 3). The company must notify all shareholders of the proposed acquisition from specific parties, giving them an opportunity to exercise this right. This mechanism aims to prevent unfair favoritism.
    • If the company acquires shares from a specific shareholder at a price that is significantly higher than the market price (or fair value if unlisted) without a justifiable reason, the directors involved may be liable to the company for the excess amount if they acted in bad faith or with gross negligence towards other shareholders.
  3. Acquisition by Board Resolution (if Authorized by Articles of Incorporation) (Article 165):
    For companies that are required to submit annual securities reports (e.g., listed companies) or meet other criteria, the articles of incorporation can authorize the board of directors to make decisions regarding the acquisition of treasury stock by agreement with shareholders (including market purchases) without requiring a shareholder resolution for each specific buyback program (Article 165, paragraph 2, applying Article 156).
    • This allows for greater flexibility and speed in executing buyback strategies, particularly for market purchases.
    • However, even under this authorization, acquisitions from specific shareholders still generally require adherence to the stricter rules mentioned above (e.g., ensuring fairness to other shareholders).

Source of Funds: The Distributable Amount (Article 461)

Regardless of the procedural route, a critical substantive limitation is that any acquisition of treasury stock for consideration must be funded from the company's "Distributable Amount" (bumpai kanō gaku) (Article 461, paragraph 1, item 1). As discussed in a previous article on distributions, this ensures that share buybacks do not impair the company's capital to the detriment of creditors. Directors involved in an acquisition that exceeds the distributable amount can face personal liability.

Effect of Procedural Violations

If a company acquires its own shares in violation of the procedural requirements (e.g., without proper shareholder or board approval, or in breach of the rules for acquiring from specific shareholders), the acquisition itself is generally considered void (mukō). Directors who authorized or executed such an illegal acquisition may be liable to the company for any damages suffered.

Other Methods of Acquiring Treasury Stock

Besides acquisition by agreement with shareholders, a company can also acquire its own shares in other specific circumstances (Article 155 lists these), including:

  • Upon exercise of a call option by the company (if shares with call options - shutoku jōkō-tsuki kabushiki - have been issued).
  • Upon a shareholder exercising a put option (if shares with put options - shutoku seikyūken-tsuki kabushiki - have been issued).
  • As part of a merger or acquisition where the target company holds shares of the acquiring company.
  • In response to a demand by heirs of a deceased shareholder of a non-public company with transfer-restricted shares, where the company has the right to demand sale from heirs (Article 176).
  • To acquire fractional shares (hasū kabushiki) that arise from stock splits, mergers, etc.

The procedural rules and source regulations for these acquisitions vary depending on the specific context.

Once acquired, treasury stock has a unique legal and accounting status:

Legal Rights of Treasury Stock (Article 308, paragraph 2, etc.)

  • No Voting Rights: A company cannot exercise voting rights for the treasury stock it holds (Article 308, paragraph 2). This is to prevent management from using treasury stock to unfairly influence shareholder votes and entrench themselves.
  • No Entitlement to Dividends or Other Shareholder Rights: Treasury stock is generally not entitled to receive dividends, distributions of residual assets, or allotments of new shares or share options (e.g., Article 453, proviso; Article 504, paragraph 3, item 1, proviso). These rights are effectively suspended while the shares are held in treasury.

The rationale is that the company, as the holder of its own shares, cannot logically exercise rights against itself or distribute assets to itself in the capacity of a shareholder.

Disposition or Cancellation of Treasury Stock

A company holding treasury stock can choose to:

  1. Hold it Indefinitely: There is generally no strict time limit for how long a company can hold treasury stock.
  2. Dispose of (Re-sell) it (Article 199 et seq.): The company can sell its treasury stock to third parties or existing shareholders. The procedures for disposing of treasury stock are largely the same as those for issuing new shares for subscription (boshū kabushiki no hakkō tō), including the determination of subscription requirements, decision-making by the appropriate corporate organ (shareholders' meeting or board), and compliance with advantageous issuance rules.
  3. Cancel (Retire) it (Article 178): The company can cancel its treasury stock by a resolution of the board of directors (or directors, if no board), provided the articles of incorporation authorize such cancellation or the cancellation is approved by shareholders. Cancellation reduces the number of issued shares but does not, by itself, reduce stated capital (a separate capital reduction procedure would be needed for that).

Accounting Treatment

The accounting for treasury stock in Japan generally follows the principle that treasury stock is a deduction from shareholders' equity, not an asset.

  • Acquisition: When treasury stock is acquired, it is typically recorded at its acquisition cost as a separate negative item within the net assets section of the balance sheet.
  • Disposition: If treasury stock is subsequently re-sold, the difference between the re-sale price and the acquisition cost is generally treated as an increase or decrease in capital surplus, not as a gain or loss in the income statement.
  • Cancellation: Cancellation of treasury stock results in a reduction of the treasury stock account and a corresponding reduction in another equity account (often retained earnings, or capital surplus if so designated).

The debate about whether treasury stock possesses "asset value" has implications for calculating damages in cases of illegal acquisition. While some argue for recognizing asset value (especially if the shares have a market price), the prevailing view in legal scholarship tends to align with the accounting treatment, considering treasury stock more as a potential source for future capital raising (akin to unissued shares) rather than a current asset generating cash flows for the company while held.

Prohibition on Acquisition of Parent Company Shares by a Subsidiary (Article 135)

A related but distinct rule is the general prohibition on a subsidiary acquiring shares of its parent company (Article 135, paragraph 1). This rule is designed to prevent:

  • Erosion of Parent Company Capital: Indirect reduction of the parent's capital if the subsidiary uses its funds (which ultimately belong to the parent's economic group) to buy parent shares.
  • Distortion of Control: The parent's management could potentially use the subsidiary to buy parent shares and then exercise voting rights in a way that benefits management rather than the parent's shareholders.

There are limited exceptions to this prohibition, such as in the course of a merger or acquisition of a business that happens to hold parent company shares.

Conclusion

The Japanese Companies Act provides a flexible yet regulated framework for Kabushiki Kaisha to acquire, hold, and dispose of their own shares. While the historical aversion to treasury stock has largely given way to a more liberal approach, the procedures – particularly the requirement for proper authorization and adherence to source regulations (the Distributable Amount) – remain critical safeguards for protecting creditors and ensuring fairness among shareholders. For companies, treasury stock transactions offer strategic tools for capital management, shareholder returns, and corporate restructuring. For investors and legal advisors, understanding the purposes, intricate procedures, and legal consequences associated with treasury stock is essential when dealing with Japanese K.K.s, especially in contexts like M&A, investment analysis, or assessing corporate governance practices.