Ichigo's Scott Callon Leads Japan's First Successful Shareholder Revolt

May 3, 2007


Scott Callon, Partner & CEO, Ichigo Asset Management, Ltd.
Wilbur L. Ross, Chairman & Chief Executive Officer, WL Ross & Co. LLC; Director, Japan Society

Scott Callon of Ichigo Asset Management spoke about his firm's landmark decision to launch what became Japan's first successful proxy solicitation, in which shareholders of steel maker Tokyo Kohtetsu rejected a proposed merger with the much larger Osaka Steel.

Tokyo Kohtetsu "is a remarkable company, a company that frankly very few people had heard of, just 100 employees in the north of Tokyo, Tochigi prefecture, with a single factory, and operating at a level of excellence in our view unrivaled by any small steel company in Japan," said Mr. Callon, formerly head of equities at Morgan Stanley Japan.

"Ichigo is this tiny little asset manager. We are not powerful. And so we did the proxy ourselves, because we had neither the time nor the money to do it any other way."

"And we had a really incredible result. We ended up with almost three-fourths of the vote of the retail shareholders, an unprecedented outcome."

On October 26, 2006, Osaka Steel agreed to buy Tokyo Kohtetsu in a stock-for-stock deal at a fixed share ratio reflecting a mere 0.3 percent premium over the one-month average price of Kohtetsu's shares--no control premium, no reflection of merger synergies or earnings accretion, Mr. Callon observed. Simultaneously, Kohtetsu reported that its earnings were up 32 percent over forecast; thus the market had no time to reflect the improved earnings profile before the deal was struck.

"We didn't think this was right," he said. In a market that trades at 20 times earnings and twice book value, the stock was trading at 6 times earnings and at a price equal to book value. Kohtetsu had an ROE in the upper 20s, and an operating margin in the low 20s--"it was and is an exceptional company."

Ichigo met with Kohtetsu's management, who "told us in private they thought that the offer was fair, and they thought the shareholders would agree," he continued. "We told them in advance we were prepared to do a proxy, because we thought that we should be very transparent." Ichigo also met with executives at Osaka Steel; indeed, the firm consulted privately with both managements before taking each step, Mr. Callon said.

Shareholder-initiated proxy solicitation had never been done in Japan before, and Ichigo had to consult with the regulators on the rules, he said.

"It was interesting how manual it was," Mr. Callon said of the proxy process. The Ichigo partners, with the help of temporary staff, "were in our little office, licking envelopes," and over a two-week period Ichigo sent some 13,000 pieces to 70 institutional shareholders and 1,200 individuals.

"My mother was a small-town mayor, so I grew up doing elections--it was very much like a campaign headquarters," he reflected.

Ichigo posted the proxy materials on the Internet and set up an inbound-only phone bank; Ms. Sanae Shimizu, another Ichigo partner, and Mr. Callon handled non-routine phone calls as needed.

"It was interesting that the company did choose to go outbound with their calls. We got a lot of feedback from shareholders saying they were unhappy with it. And remember the shareholders of Kohtetsu are all over the country. And so we would literally get these calls from people and they'd say 'some slick-talking guy with a Tokyo accent has just called me, and he refused to introduce himself.'" Thus the company's outbound calls "ended up backfiring," in Mr. Callon's view.

What Ichigo didn't do was as important as what it did do, he indicated. Ichigo did not attack Kohtetsu's management, which it believes is excellent, and it publicly abandoned its appraisal rights, namely its ability to challenge the shareholder vote in court should it lose.

In an interview with a reporter for a major Japanese newspaper, Mr. Callon was asked, "Are you going to be seeking appraisal rights?"

"And I said no, and he said--this is all in Japanese, but he said, 'Now I finally believe you.' And I was so stunned by that, because we had been talking for over an hour, and I said, 'You didn't believe anything I said before?' And he said, 'Well, you know, I guess I didn't.'"

Mr. Callon concluded with three lessons learned from the Kohtetsu vote:

First, although individuals are busy, working, retired, elderly, without the resources that institutions have, "it was in fact the votes of the individuals that were fundamental to this outcome."

The merger deal required a two-thirds vote for approval. Of the 42 percent voting against the deal, 11 percent came from Ichigo, 8 from institutions, and the balance from individuals, he noted. Thus the percentage of shares voted by retail holders against the merger represented more than twice the percentage of Ichigo shares.

Second, Kohtetsu's holders had done their homework: shareholders who called in lectured Ichigo on the research they had done on their own to value Osaka Steel and Kohtetsu, and some urged a much larger premium than the 30 percent Ichigo had proposed.

And third, the zero-interest-rate environment in Japan "had an important demographic effect." Many Kohtetsu shareholders were indeed older people, and for them, Kohtetsu's dividends made the stock an attractive investment vehicle for their lump-sum retirement payments.


What is the mindset of Japanese shareholders?

"In Japan, companies are not just boxes where capital and people flow in and out," answered Mr. Callon. "They are social institutions."

"The central social contract for the core employees remains, and it's not easy to jump around from company to company. There is thus significant employee commitment. When I visit managements, they've usually been there for 20 or 30 years, and I have a huge amount of respect for them."

"And so, in interacting with shareholders in Japan, I think it's appropriate to recognize that cultural and societal context."

Going in, why did you think that the company was undervalued? Why was management willing to take less than what you thought the real value was?

Between 2002 and 2006, some 40 percent of the company's stock came onto the market from sales by heirs of the founding family and by the Japanese Ministry of Finance, the company's largest shareholder, which had received the shares as payment for inheritance tax. "The stock was just crushed."

Kohtetsu's management was concerned about the possibility of a future economic downturn, however, and wanted to sell the company. "There's no question in my mind that management felt that this was the right transaction, that they felt that it was in the best interest of Kohtetsu to sell the company to Osaka Steel." It's only been six weeks since the vote, but with Kohtetsu up 28 percent over a pro forma price based on the Osaka Steel share ratio, the shareholders' decision seems right, he added.

What is it about Japan, or about this situation, that gave you the opportunity that it did, and is this the kind of thing that would happen only rarely?

"What's fundamental about this is that we stepped out of a market process into a corporate governance process," responded Mr. Callon. "This is a classic tool: you go to the shareholders."

Indeed, Japanese shareholders have "incredibly strong" legal rights. "Japan is not a board-level governance regime; it is a shareholder-meeting regime."

"Shareholders can call a shareholder meeting at will." They can add resolutions to the meeting's agenda, at will; "and if it passes as a shareholder resolution, it's company policy."

If shareholders want to triple the dividend, "and they pass a resolution, it just got tripled; it doesn't matter what the board says."

"However, the challenge that some global activists have had is they show up and they propose a big dividend increase, and the shareholders don't vote for it. Because for Japanese shareholders sometimes it is too drastic, and it feels like it is taking hard-earned savings over many, many years, and distributing them to current shareholders at the expense of employees."

The issues in Japan thus "are not structural," he said. "The issues are really more fundamentally about being able to work for something that resonates with the other shareholders."

What was different about this deal that allowed you to take this step?

"I don't know the answer. The reality is, we didn't think we were going to win, but we wanted to create a positive precedent of supporting shareholder rights in a respectful way, and we thought there was a chance of at least getting close to winning," Mr. Callon replied.

"No one else tried, before. Really, that's what it comes down to."

As you were negotiating, you made the decision to be ready to mail if the company turned you down, and your mailing reached shareholders days before the company's letters did, is that right?

That's correct, Mr. Callon said. "It's impossible to know what the counterfactual looks like," to know if that timing made a difference. Ichigo hoped for a yes from Kohtetsu's management, but decided it needed to be prepared for a no.

How do institutional investors in Japan view shareholder democracy?

"Many asset managers worry about the brand risk, and don't want to be out there in the headlines, disagreeing with management," Mr. Callon replied. Institutional voting was very limited, which in his view is unfortunate. "We need, at a minimum, their vote."

What was Ichigo's cost?

"All in, less than $200,000. If we had to do it again, I would guess $70,000," since with the Kohtetsu proxy "we spent tons of time with lawyers trying to figure out how we were supposed to do it, and now we know."

Could the company have postponed the shareholder meeting?

Yes, "and we would have been fine with that," he answered.

Ichigo's goal was to be "different, in a respectful way." It couldn't go along with the idea "that the choice was between passive shareholding," the most extreme form being cross-shareholding, which blocks shareholders from exercising their rights, and "a sort of attack-style activism."

"At the end of the day, we wanted to stand up for shareholders. And if we walked away on this, who was going to do it? But it was a difficult process."

Could you and Mr. Ross both speak on the question of hostile offers, Steel Partners and Sapporo and other transactions?

Presider Wilbur Ross of WL Ross & Co. responded, "As some of you know we operate a fund called Taiyo, which is an activist fund but does not do hostile transactions. Maybe one step removed even from what Scott is doing."

"We found in general that there's a whole group of Japanese managements who would like to improve corporate governance, and are happy to work with the large individual outside holder."

"In our own case, our policy is not to go over 5 percent unless the management is willing to issue a press release welcoming us, so that's how far we go. So what we do is if the management doesn't want to do what we think are good things, we just don't get to a major position; we exit. So it's a degree farther passive, but not passive."

"And my guess is that Scott's preference would be that he never had to do a proxy fight, that they had been able to reason it out with the management."

Mr. Callon concurred. "As Wilbur pointed out though, we do take the hard cases. Some of the biggest misvaluations, and therefore the most shareholder suffering, are with managements who have been somewhat intransigent, and we try to work though those situations to create a more positive outcome."

How extensive was the media coverage?

Media coverage was significant. "But at start I knew none of the media, so I took every meeting," every interview request, and they were usually long interviews, an hour or two long, replied Mr. Callon.

People always ask about the impact of being a foreigner--"I'm an American, and I also am an immigrant to Japan. I've been there nearly two decades. I have the Japanese equivalent of a green card. My wife's also American, but we've raised our family in Japan, and we are all Japanese speakers. At the end of the day, the Japanese media were very fair. I am grateful for that."

Do you see shareholder activism in Japan being relatively restricted?

The Kohtetsu vote, shareholders' challenge to restaurant company Rex Holdings' MBO, a third-party offer of an 83 percent premium for real estate company TOC after management had offered a 30 percent premium--these are three recent instances where the shareholder market is saying "this has been mispriced, and we're not going to lie down, we're going to challenge it," Mr. Callon responded.

"If your question is, should you bet on more shareholder activism in Japan, I think the answer is yes."

--Katherine Hyde

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