Capital Injection and Strategic Partnerships: Understanding New Share Issuances (Third-Party Allotments) in Japanese M&A

A new share issuance (新株発行 - shinkabu hakkō), particularly through a third-party allotment (第三者割当 - daisansha wariate), is a significant corporate finance tool and a strategic mechanism often employed in the context of Mergers and Acquisitions (M&A) in Japan. Unlike secondary sales where existing shares change hands, a new share issuance involves the company creating and selling additional shares, thereby increasing its capital. The disposal of treasury shares (自己株式の処分 - jiko kabushiki no shobun) by a company also generally follows similar procedural rules under the Japanese Companies Act.

This method serves various purposes, from straightforward capital raising to forging strategic alliances and, in some instances, facilitating shifts in corporate control. Understanding its applications, tax implications, the distinct procedural requirements for private and public companies, and the potential legal remedies against improper issuances is crucial for businesses and investors operating in Japan.

I. Significance and Application Scenarios of New Share Issuances

The decision to issue new shares to third parties is typically driven by specific strategic or financial needs of the issuing company.

A. Primary Purpose: Capital Injection for Growth and Stability
The most fundamental reason for a new share issuance is to raise capital directly for the company. The proceeds can be used to:

• Strengthen the company's financial base and improve its balance sheet.
• Fund new investments, such as research and development, capital expenditures, or market expansion.
• Reduce existing debt obligations.
• Provide working capital for ongoing operations or new projects.
  This direct infusion of funds into the company's treasury distinguishes it from a sale of existing shares by current shareholders.

B. Facilitating Changes in Control (支配権の移転 - Shihaiken no Iten)
While a substantial allotment of new shares to a single party or a coordinated group can lead to a significant shift in voting power and potentially a change of control, it's generally a less direct route to acquiring 100% control compared to a comprehensive share purchase from existing shareholders. In a new share issuance, existing shareholders retain their pre-existing shares, although their proportionate ownership is diluted.
A third-party allotment is often used in M&A scenarios where:

• The target company is in need of fresh capital for its operations or growth, AND
• The acquirer wishes to obtain a significant equity stake, potentially leading to control, by injecting that capital.
  Achieving outright 100% control solely through a new share issuance is generally not feasible unless, for instance, all existing shares were simultaneously subject to an acquisition clause exercisable by the company.

C. Forging Strategic Alliances and Joint Ventures (資本提携・合弁 - Shihon Teikei / Gōben)
Third-party allotments are a very common method for establishing or solidifying strategic alliances. One company (the investor) subscribes to newly issued shares of another company (the issuer) to:

• Formalize a business partnership.
• Collaborate on specific projects, research, or technology development.
• Jointly enter new markets or customer segments.
• Secure long-term supply or distribution arrangements.
  Such an investment is often accompanied by a separate business alliance agreement or a shareholders' agreement that outlines the strategic cooperation and governance arrangements between the parties.

D. Other Applications
In certain, less frequent situations, a targeted new share issuance might be considered as part of a financial restructuring or even, controversially, as a defensive measure against an unsolicited takeover attempt (by issuing shares to a friendly "white knight"). However, issuances perceived as primarily serving defensive or entrenchment purposes, rather than legitimate corporate needs, face high scrutiny and risk legal challenge.

II. Key Tax Implications (税務上のポイント - Zeimu-jō no Pointo)

The tax treatment of new share issuances is a critical consideration for both the issuing company and the subscribers.

A. General Rule: Non-Taxable Event for Issuer and Subscriber (at Fair Market Value)

• For the Issuing Company: When shares are issued at fair market value, the proceeds received are generally not treated as taxable income. The amount corresponding to the issue price is typically recorded as an increase in stated capital (資本金 - shihonkin) and capital surplus (資本準備金 - shihon junbikin) on the balance sheet.
• For the Subscriber: Acquiring shares by paying the fair market value is considered an investment. There are generally no immediate income tax consequences for the subscriber at the time of acquisition; the amount paid becomes their tax basis in the shares.

B. "Favorable Issuance" (有利発行 - Yūri Hakkō) and its Tax Consequences
A significant exception to the general rule arises if new shares are issued to a third party at a price that is deemed "particularly favorable" – meaning substantially below the shares' fair market value (FMV) at the time of issuance. Such favorable issuances can trigger immediate tax liabilities for the subscriber, as the difference between the FMV and the actual issue price may be considered a taxable economic benefit.

• Individual Subscribers:
  • If the subscriber is related to a shareholder of a family-controlled issuing company, the benefit could be treated as gift income subject to gift tax.
  • If the subscriber is an officer or employee of the issuing company, the benefit could be taxed as employment income (給与所得 - kyūyo shotoku) or retirement income (退職所得 - taishoku shotoku).
  • For other individuals, it might be considered temporary income (一時所得 - ichiji shotoku).
• Corporate Subscribers: For a corporate subscriber, the economic benefit (FMV less issue price) may be treated as taxable deemed donation income (受贈益 - juzōeki).
  Determining FMV and what constitutes a "particularly favorable" price can be complex and is subject to scrutiny by tax authorities.

C. Capitalization Rules and Their Tax Relevance (資本金の金額 - Shihonkin no Kingaku)
Under Article 445 of the Japanese Companies Act, when new shares are issued, at least half of the total amount paid in by subscribers must be recorded as stated capital (shihonkin). The remaining portion, if any, can be allocated to capital surplus (shihon junbikin).
The amount of a company's stated capital can have significant tax implications in Japan, particularly for SMEs. Companies with stated capital of ¥100 million or less may be eligible for certain preferential tax treatments, such as:

• Reduced corporate income tax rates on a portion of their income.
• Exemption from certain local enterprise taxes that are based on company size (e.g., capital levy).
• More favorable rules for entertainment expenses or other deductions.
  Therefore, the decision on how to allocate the proceeds between stated capital and capital surplus is not merely an accounting entry but can be a strategic tax planning point for the issuing company.

III. Procedures for Third-Party Allotment in Private Companies (非公開会社 - Hi-kōkai Gaisha)

Private companies (those whose shares are not publicly traded and typically have transfer restrictions on all their shares) must follow a detailed set of procedures under the Companies Act for third-party allotments.

A. Determination of Subscription Requirements (募集事項の決定 - Boshū Jikō no Kettei)
The first step is to formally decide on the terms of the new share issuance.

• Approving Body: For a private company, the determination of these "subscription requirements" generally requires a special resolution of a shareholders' meeting (株主総会特別決議 - kabunushi sōkai tokubetsu ketsugi) (Companies Act, Article 199, Paragraph 2 and Article 309, Paragraph 2, Item (v)). A special resolution typically requires the approval of shareholders holding a majority of all voting rights who are present at a meeting, and representing at least two-thirds of the votes cast.
• Delegation to Directors: Shareholders can, by a special resolution, delegate the authority to determine some or all of the subscription requirements to the board of directors (取締役会 - torishimariyakukai) or, if no board exists, to the representative director. However, this delegation must specify the maximum number of shares that can be issued and the minimum issue price (or its calculation method). Such a delegation is generally valid for a period of up to one year from the date of the shareholders' resolution (Companies Act, Article 200).
• Key Subscription Requirements (募集事項 - Boshū Jikō) (Companies Act, Article 199, Paragraph 1):
  1. The number and class (if applicable) of shares to be offered for subscription.
  2. The issue price per share (払込金額 - haraikomi kingaku) or the method for calculating it.
  3. If assets other than cash (in-kind contributions - 現物出資 genbutsu shusshi) are to be accepted as payment, a description of those assets and their value (subject to valuation rules under Article 207).
  4. The date by which payment must be made (払込期日 - haraikomi kijitsu) or the period during which payment can be made (払込期間 - haraikomi kikan) (Article 208).
  5. The amount by which stated capital and capital surplus will be increased (as per Article 445).
• "Particularly Favorable" Issuance (有利発行 - Yūri Hakkō): If the issue price is set at a level that is "particularly favorable" to the subscribers (i.e., substantially below fair market value), the directors must explain the reasons for such favorable terms at the shareholders' meeting approving the issuance (Article 199, Paragraph 3). This triggers heightened scrutiny.
• Class Shareholder Approval: If the company has different classes of shares and the new issuance would prejudice the rights of shareholders of a particular class, a separate resolution by a meeting of shareholders of that affected class may also be required (Article 199, Paragraph 4).

B. Offer and Allotment Process (申込みと割当て - Mōshikomi to Wariate)
Once the subscription requirements are determined:

1. Notification to Potential Subscribers: The company must provide persons intending to subscribe for the new shares with the determined subscription requirements and certain other prescribed information about the company (Companies Act, Article 203).
2. Subscription Applications: Interested persons apply to subscribe for shares, typically in writing (or electronically, if the company consents), specifying the number of shares they wish to acquire.
3. Allotment Decision: The company (through its board of directors, or by shareholders if so stipulated or if no board exists) then decides to whom among the applicants it will allot the new shares and the number of shares to be allotted to each (Companies Act, Article 204). The company is not obligated to allot shares to all applicants or in the amounts requested.
4. Notification of Allotment: The company must notify the successful applicants of the number of shares allotted to them before the payment due date.
5. Subscription Agreement for All Shares (総数引受契約 - Sōsū Hikiuke Keiyaku): A common simplification, especially in strategic investments or where there's a single or small group of predetermined investors, is for the company to enter into a "subscription agreement for all shares" (Article 205). In this case, the subscribers contractually commit to take up all the offered new shares, and the individual application and allotment notification steps above can be omitted. However, if the issuance involves restricted shares, the sōsū hikiuke keiyaku itself still requires approval by a (special) shareholders' resolution or board resolution, as applicable.

C. Payment for Shares (出資の履行 - Shusshi no Rikō)
Subscribers to whom shares have been allotted must pay the full issue price for those shares.

• Cash Payment: Payment must be made in cash to a financial institution designated by the company, by the specified payment date (haraikomi kijitsu) or within the specified payment period (haraikomi kikan) (Companies Act, Article 208).
• In-Kind Contributions (現物出資 - Genbutsu Shusshi): If assets other than cash are being contributed, these assets must be delivered to the company by the payment date or within the payment period. The Companies Act (Article 207) contains strict rules for the valuation of in-kind contributions to ensure fairness to other shareholders and creditors. Generally, a court-appointed inspector must verify the value of the contributed assets, unless certain exceptions apply (e.g., if the total value is below a certain threshold, if the assets are publicly traded securities valued at no more than their market price, or if the value is certified by a qualified professional like a lawyer or CPA).

D. Effective Date of Share Issuance (効力の発生 - Kōryoku no Hassei)
Subscribers become shareholders on:

• The specified payment date (haraikomi kijitsu), if one was set, provided they have made full payment by that date.
• The date on which they make full payment, if a payment period (haraikomi kikan) was set.
  Failure to make full payment by the deadline results in the forfeiture of the right to receive the shares.

E. Registration of Changes with Legal Affairs Bureau (変更登記 - Henkō Tōki)
Following the share issuance, the company must register the increase in its stated capital and the total number of issued shares (and any changes in classes of shares) with the competent Legal Affairs Bureau (法務局 - Hōmukyoku) within two weeks of the date the issuance took effect.

IV. Procedures for Third-Party Allotment in Public Companies (公開会社 - Kōkai Gaisha)

Public companies (generally, companies whose shares are listed on a stock exchange, or unlisted companies whose Articles of Incorporation do not restrict the transfer of all classes of their shares) have slightly different, often more streamlined, procedures for determining subscription requirements, but also additional disclosure obligations.

A. Determination of Subscription Requirements:

• Approving Body: For a public company, the determination of subscription requirements is generally made by a resolution of the board of directors (Companies Act, Article 201, Paragraph 1), unless the company's Articles of Incorporation specifically reserve this authority for a shareholders' meeting.
• "Particularly Favorable" Issuance (有利発行 - Yūri Hakkō): However, similar to private companies, if the issue price is "particularly favorable" to the subscribers, a special resolution of a shareholders' meeting is still required (Article 201, Paragraph 1, referencing Article 199, Paragraphs 2 and 3, and Article 309, Paragraph 2, Item (v)). Directors must also explain the reasons for such favorable terms.

B. Disclosure to Existing Shareholders (株主に対する開示 - Kabunushi ni Taisuru Kaiji)
To protect the interests of existing shareholders from potential dilution or unfair issuances, public companies have specific disclosure obligations:

• Notification or Public Notice: A public company that has resolved (by its board) to issue new shares must, as a general rule, notify its shareholders of the subscription requirements or make a public notice of these requirements at least two weeks before the payment date (or the first day of the payment period) (Companies Act, Article 201, Paragraphs 3 and 4). This provides shareholders with an opportunity to scrutinize the proposed issuance and, if they believe it is illegal or grossly unfair, to seek a court injunction (see below).
• Special Rules for Issuances Causing Significant Dilution or Change of Control (支配株主の異動を伴う場合など - Shihai Kabunushi no Idō o Tomonau Baai Nado):
  • Issuance to a "Specified Subscriber" (特定引受人 - Tokutei Hikiukenin) (Companies Act, Article 206-2): If a third-party allotment in a public company would result in a subscriber (the "specified subscriber") acquiring such number of shares that their voting rights would exceed 50% of all shareholders, or if the allotment would dilute existing shareholders by a certain significant percentage (often also governed by stock exchange listing rules for listed companies), more stringent procedures apply. The company must notify shareholders of specific details about the specified subscriber and the rationale for the allotment. If shareholders holding one-tenth or more of the total voting rights object within two weeks of such notification, the company must obtain approval for the allotment by a resolution of a shareholders' meeting (usually an ordinary resolution, but the threshold can be raised by the Articles) before the payment date, unless certain urgent circumstances exist (e.g., severe financial distress requiring immediate capital).
  • Stock Exchange Rules for Listed Companies: Listed companies are also subject to the rules of the stock exchange on which they are listed. These rules often impose additional requirements regarding third-party allotments, particularly concerning pricing (to avoid excessive discounts to market price without shareholder approval), disclosure, the necessity of obtaining opinions from independent third parties or audit & supervisory committee members if the allotment is to a related party or involves significant dilution, and sometimes, shareholder approval even if not strictly required by the Companies Act.

C. Other Procedural Steps:
The subsequent steps of offer, allotment, payment by subscribers, the effective date of the issuance, and registration of changes with the Legal Affairs Bureau generally follow a similar pattern to those for private companies, but always within the framework of continuous disclosure obligations for listed entities.

V. Remedies Against Improper New Share Issuances

The Companies Act provides shareholders with legal remedies if they believe a new share issuance is being conducted improperly.

A. Injunction (発行等の差止め - Hakkō tō no Sashitome) (Companies Act, Article 210)
A shareholder who is likely to suffer a disadvantage may petition a court for an injunction to stop a new share issuance if it:

1. Violates laws or the company's Articles of Incorporation (e.g., issuance exceeding the authorized number of shares, lack of necessary corporate approvals, issuance of an unauthorized class of shares).
2. Is conducted by a "grossly unfair method" (著しく不公正な方法 - ichijirushiku fukōsei na hōhō). This often arises in the context of control disputes, where an issuance is perceived as being primarily intended to dilute the voting power of certain shareholders or to entrench existing management, rather than serving a legitimate corporate purpose (the "primary purpose test" is often judicially applied).
   An injunction is typically sought through a provisional disposition (仮処分 - karishobun), which is a relatively expedited court procedure.

B. Nullification of Share Issuance (新株発行の無効 - Shinkabu Hakkō no Mukō) (Companies Act, Article 828, Paragraph 1, Item (ii))
If a new share issuance has already taken effect, it can only be nullified by filing a lawsuit (無効の訴え - mukō no uttae).

• Standing to Sue and Time Limits: Such a lawsuit can be filed by shareholders, directors, statutory auditors (kansayaku), or liquidators. There is a strict time limit: for public companies, the action must be filed within six months of the effective date of the share issuance; for private companies, the period is one year.
• Grounds for Nullification: The Companies Act does not exhaustively list the grounds. However, nullification is generally granted only for serious procedural or substantive defects that undermine the legality or fairness of the issuance to a fundamental degree. Examples might include:
  • Issuance of shares exceeding the total number of authorized shares under the Articles of Incorporation.
  • Issuance of a class of shares not authorized by the Articles of Incorporation.
  • A fundamental defect in the required shareholder or board resolution (e.g., issuance of restricted shares without proper approval).
  • A complete failure to provide legally required notice or public notice to shareholders that deprived them of the opportunity to seek an injunction (as suggested by some court precedents).
  • Issuance in direct violation of a court-ordered injunction.
    Japanese courts tend to be cautious about nullifying share issuances once they have taken effect, due to the potential disruption to legal stability and third-party transactions. Thus, only very material and clear defects are likely to succeed. For instance, past Supreme Court cases have shown reluctance to nullify issuances merely due to the lack of a board resolution (where the board had authority) or even the lack of shareholder approval for a "particularly favorable" issuance, if other aspects were deemed to uphold the transaction's overall validity in the specific circumstances.

C. Action for Non-Existence of Share Issuance (新株発行不存在確認の訴え - Shinkabu Hakkō Fusonzai Kakunin no Uttae) (Companies Act, Article 829)
In cases of extremely severe defects where it can be argued that, legally, no share issuance can be deemed to have occurred at all (e.g., a complete fiction), an action to confirm the non-existence of the share issuance may be possible.

D. Civil Liability of Directors and Subscribers (民事責任 - Minji Sekinin) (Companies Act, Articles 212, 213, etc.)
Directors may be held liable to the company for damages if they act improperly or negligently in connection with a new share issuance (e.g., by issuing shares at a grossly unfair price without legitimate justification, causing financial loss to the company). Furthermore, subscribers who acquire shares at a "particularly favorable" price may be liable to the company for the difference between that price and a fair issue price (Article 212). There are also specific liability provisions concerning "pretended payments" (見せ金 - misekin), where payment for shares is made only superficially.

Conclusion: A Versatile Tool Requiring Careful Execution

New share issuance through a third-party allotment provides Japanese companies with a versatile instrument for raising capital, forging strategic partnerships, and effecting changes in their shareholder structure. However, its execution is governed by a detailed and strict set of procedural requirements under the Companies Act, designed to protect the interests of existing shareholders and ensure fairness.

Adherence to these procedures, particularly concerning shareholder approvals (especially for private companies or in cases of favorable issuance for public companies), proper determination and disclosure of subscription requirements, and adherence to valuation principles for in-kind contributions, is paramount to avoid potential legal challenges such as injunctions or nullification actions. The distinctions in procedures between private and public companies, the heightened scrutiny for "particularly favorable" issuances, and the potential tax implications for subscribers in such cases, are all critical areas demanding careful attention and expert legal and financial advice.