RIETI Policy Symposium

Emerging Patterns of Corporate Governance among Japanese Firms - Converging to Any Specific Model?

Information

  • Date and Time: 20 October (Wed.), 2004. 9:00-18:00
  • Venue: Elizabeth Rose Hall, United Nations University (Shibuya-ku, Tokyo)
  • Language: Japanese / English (with simultaneous interpretation)
  • Pros and Cons

    International Symposium "Emerging Patterns of Corporate Governance among Japanese Firms - Converging to Any Specific Model?"

    On October 20, 2004, the Research Institute of Economy, Trade and Industry (RIETI) hosted an international symposium, "Emerging Patterns of Corporate Governance among Japanese Firms: Converging to Any Specific Model?" During the symposium, the following topics were debated and participants were confronted with findings from the latest empirical research: (1) changes in the governance role of banks; (2) the impact of foreign institutional investors on Japanese firms; (3) legal reform of corporate boards; and (4) the issue of convergence and possibility of a new "hybrid" model of corporate governance in Japan. The objective of this report is to summarize "pro" and "con" arguments on important issues discussed at the symposium, and to clearly define those issues. We would appreciate hearing your views on the comments and analysis presented here.

    1) Background of the Debate

    a) Japanese corporations have faced a variety of new corporate governance dilemmas since the 1990s. During much of the postwar period, corporate governance of Japanese firms could be described as a bank-based or stakeholder-oriented model. Main banks were the major external monitors of corporate management, employees enjoyed a strong position within the firm, and corporate management was composed of internally promoted insiders socialized into the corporate culture based on long-term relationships. This pattern was remarkably different than, for example, U.S. corporate governance with its emphasis on shareholder rights, market pressure by institutional investors, outside directors and more arm's-length relations with employees. Despite the remarkable success of the Japanese system, serious pressures mounted following the collapse of the bubble economy and culminated in a substantial period of reform and change since the mid-1990s. Japan has thus faced declining average corporate performance according to indicators such as return on assets (ROA), but also an increasing variance in the performance of firms (Miyajima).

    b) International finance and investors have become increasingly important for Japanese firms. Foreign investors owned 18.3% of stocks listed on the Tokyo Stock exchange in 2002, compared to 4% in 1990. Foreigners accounted for just 9.8% of stock market transactions in 1990, but 31.7% in 2002. In addition, bond finance now plays an increasing role in substituting for indirect financing via banks. Bond ratings given by international credit agencies are thus of growing concern for Japanese firms seeking external finance. Moreover, foreign direct investment into Japan has increased, and foreign companies have made unprecedented acquisitions of large stakes in companies such as Nissan and Mitsubishi Motors. Overall inward FDI relative to GDP remains extremely low in Japan compared to other developed countries, but there is increased concern about corporate reforms designed to attract more international investment, such as reducing cross-shareholdings, facilitating M&A, privatizing government businesses, and liberalizing the use of stock options that U.S. and other foreign firms see as necessary to attract qualified staff. Given the increasing relevance of international financial flows, international standards are also playing a growing role in the regulation of Japanese firms. New social norms surrounding corporate governance are being introduced to Japan from abroad, as witnessed by various policy discussions over corporate law and the introduction of self-regulatory guidelines and codes for firms or investors. International standards may have increasing extraterritorial application to Japanese companies, as in the case of international accounting standards, or most recently the Sarbanes-Oxley Act.

    c) Financial deregulation in the 1980s and the collapse of the bubble economy contributed to the huge problem of non-performing loans (NPLs) held by Japanese banks. The NPL crisis has greatly eroded the capacity of banks to play their former beneficial role in corporate governance. While greater availability of both internal and direct finance liberated large firms from their dependence on banks, the banks themselves became more dependent on smaller and riskier clients. The accumulation of NPLs and indecisive government policies led to a paradoxical situation: Whereas potentially worthy firms faced a growing credit crunch, loans to bankrupt clients were continuously rolled over. The banking crisis prompted political debate over transparency, accounting rules and generally about relations between banks and industry. More generally, it became impossible to maintain the old model of main bank relationships.

    d) Changes in the organizational architecture of Japanese firms also raise new challenges for corporate governance. The advent of modular production technologies has led to dramatic changes in corporate structure, such as the degree of hierarchical coordination and horizontal information-sharing across business units. Specifically, it is argued that information technology gave renewed competitive strength to the U.S. due to its liquid stock markets, venture capital, and strong external labor markets that rely on portable professional qualifications. Meanwhile, Japanese corporate governance has tended to support more integrated and network-based production based on incremental innovation and the strong development of shop-floor skills. Moreover, Japanese corporate governance has been very strong in supporting long-term investment through strong bank-firm relationships during the period of rapid postwar economic expansion, but may be less well adapted to disciplining companies facing slow growth.

    e) Japan has experienced a prolonged debate about corporate governance reform. Reformers have advocated changing to a more market-oriented governance paradigm, particularly given the upswing in U.S. economic performance during the late 1990s and the dominant notion of "shareholder-value" among Anglo-American academics. Dissatisfaction with Japanese practices was also prompted by various corporate scandals. Meanwhile, many critics of these reform efforts have warned that importing U.S.-style, shareholder-oriented governance practices may also undermine past strengths of Japanese firms as well as erode solidarity and equality within Japanese society. The politics of corporate governance reform in Japan are accordingly characterized by ambiguity about the nature of the problem itself, as well as deep ambivalence as to the solutions. Corporate governance reform has been incremental, taking place through amendments to the Commercial Code and other related laws.

    2) What role are Japanese banks currently playing within corporate governance? To what extent have the "bright sides" of long-term finance and contingent governance by the main bank been overshadowed by "dark sides" that hinder corporate restructuring?

    a) Con Viewpoint : The monitoring capacity and positive governance role of Japanese banks has seriously eroded as a consequence of the banking crisis.

    i) The financing characteristics of Japanese firms bifurcated during the 1990s. Large firms shifted their finance from bank borrowing to bonds (about 20% of firms, but 68% of asset value and 57% of employment), whereas smaller firms with low growth expectations have become more dependent on bank finance rather than less (Miyajima and Arikawa).

    ii) This adverse selection increasingly exposed Japanese banks to the risk of moral hazard and led to the deterioration of the banks' lending portfolio. The well-known consequence was the nonperforming loans crisis.

    iii) Empirical investigations show the weakening position of banks has substantially eroded their capacity to act as effective monitors (Miyajima and Arikawa). In the late 1990s, an "evergreen policy" can be observed, since firms with higher bank dependence were less likely to restructure employment. At the same time, bank-dependent firms with high growth opportunities invested less than firms without bank dependence, suggesting a "credit crunch" as banks were unable to foreclose on bad loans and take advantage of better lending opportunities. These facts suggest a substantial change in the former "contingent governance" role of the banks.

    iv) Thus, existing pressures push toward a bifurcation of financing patterns between sectors within Japan. Large international firms will move toward capital-market-oriented control, whereas small firms will seek to uphold more traditional relations.

    b) Pro Viewpoint : The monitoring capacity of Japanese banks will improve along with the recovery of banks' health.

    i) The demand for bank finance by SMEs will not disappear (Miyajima and Arikawa). The large SME segment in Japan means the demand for bond finance and equity finance will remain limited. These firms remain too small to access public finance markets, and thus relational finance from banks can fill this gap.

    ii) Relational financing may now be undergoing a partial reconstitution, with a focus on securities underwriting and risk management rather than traditional credit. The extension of automatic credit lines has become another popular but very debt instrument offered by main banks (Miyajima and Arikawa). Bank mergers may also help recapture scale and informational advantages, as well as eliminate excess competition.

    iii) Banks will forge new roles be within a more complex menu of governance mechanisms than in past, including formal bankruptcy procedures and private equity investment (Xu). Mergers have also brought together firms from competing keiretsu groups and may help "organize" the emerging M&A market by promoting consolidations across these same group lines. The securities divisions of some major banks now play an important role in the domestic M&A market.

    iv) Recent improvements in formal bankruptcy procedures will also help banks. As traditional monitoring by banks has weakened, their governance roles under financial stress have become more specialized and the procedures more diverse. Under recent reforms, formal bankruptcy procedures have become more common, but also more efficient (Xu). Banks play an important role in this, as they spin-off or establish separate divisions or subsidiaries to deal specifically with issues of corporate restructuring (Horiuchi). Moreover, the availability of efficient bankruptcy procedures may make the threat of intervention by the main bank more credible (Miyajima).

    v) The implications of the foregoing points are that relational banking will continue to play a central role in corporate governance among medium-size firms and business groups in Japan. The scope of the main bank system will be more limited than in the past. But the effectiveness of this role remains contingent on the health of the banks themselves.

    c) Remaining Issues

    i) The Japanese financial system remains bank-dominated. Pension reforms have not substantially shifted household savings into equity-based instruments. Also income inequality remains relatively low in Japan, reducing the demand for riskier equity based investments. Thus, supply-side factors point to the continuing importance of bank savings as the primary recipient of domestic savings.

    ii) Who monitors the monitor? Corporate governance in the banking sector remains an important but unresolved issue (Horiuchi). Since ownership of large banks is largely dispersed, or in the hands of stable shareholders, it remains unclear to what extent banks may face external discipline. To the extent that foreign investors and domestic institutional investors hold their stocks, banks may also face pressures toward greater shareholder orientation. Another aspect concerns the appropriate role of the Ministry of Finance and regulatory agencies such as the Financial Services Agency in assuring good governance practices in the banking sector.

    iii) Policy measures for bank health. Bank health remains key to banks taking on a positive function as a monitor in the corporate sector. Additional research is needed to evaluate policy options and to propose further alternatives to improve bank health.

    iv) Will improvement in the health of banks lead to the resurrection of their main-bank functions? A tentative answer is that healthy banks could continue to play a key role in SME finance. However, it remains unlikely that main bank relationships will be restored with large firms to the same extent as in the past.

    v) To what extent is relationship banking possible in a market-oriented regulatory environment? Financial liberalization has reduced the monopolistic rents of banks that were supported by regulated competition. But in addition, the more rules-based regulatory regime has made it harder for banks to maintain long-term relationships by increasing transparency and public disclosure, thus devaluing informational rents generated by the bank "asset" of private information with client firms. In this sense, a viable hybrid between relationship banking and capital market-oriented control remains hard to achieve. More research will be needed, focused on bank strategy under new regulatory conditions.

    vi) The role of the Industrial Revitalization Corporation of Japan (IRCJ). Given the decline of traditional bank monitoring and the increase of restructuring through private equity, open questions remain as to the role and effectiveness of the IRCJ.

    3) Will domestic and foreign institutional investors become a major external force in corporate governance?

    a) Pro Viewpoint : Foreign investors have a large impact on management behavior such as transparency, board reform and corporate restructuring.

    i) Foreign investors influence Japanese management by the threat of exit (Ahmadjian). The overall percentage of shares owned by foreigners in Japan has increased greatly over the last decade, whereas stable cross-shareholdings among Japanese companies has declined (Miyajima). Equally important, the proportion of share turnover accounted for by foreigners has reached nearly 30%. Thus, the decisions of foreign investors whether to buy or sell shares have a huge impact on share prices, and it is often domestic investors who follow the lead of foreign investors when shifting portfolios.

    ii) Foreign investors influence management through voice, particularly informal dialogue (Ahmadjian). Large institutional investors also have some capacity to make their voices heard by Japanese top management. Investors often maintain active relationships with firms, while Japanese firms have increasingly created dedicated investor relations departments (Miyajima) and engage in "road shows" and presentations for analysts.

    iii) Recent studies have documented a strong relationship between the percentage of shares owned by foreigners and corporate behavior. First, firms with higher foreign ownership are more likely to implement a variety of corporate governance reforms. Those firms scored higher on both the JCG Index (Ahmadjian) and on an index derived from a recent Ministry of Finance survey (Miyajima). Those firms are especially more likely to increase transparency and information disclosure to outsiders, but also are more likely to engage in reform of the board of directors. Second, foreign ownership has also had a positive impact on employment adjustment, specifically on the likelihood of reducing employment levels (Ahmadjian) or reducing seniority-related pay (Jackson). Similarly, firms with higher foreign ownership are more likely to divest existing assets. Therefore some positive relationship exists between foreign ownership and the degree of corporate restructuring.

    b) Con Viewpoint : The active governance role of foreign investors remains limited and focused only on select firms.

    i) Foreigners invest in only a very selective part of the overall Japanese stock market. Institutional investors such as pension funds tend to invest only in large, blue chip firms that are well known internationally and export to foreign markets (Ahmadjian). A key issue for investors is whether a firm's shares have sufficient liquidity to facilitate easy buying and selling of large stakes. Only around 10% of TSE section firms have foreign shareholding ratios of over 20%, whereas over half have foreign shareholding ratios under 5%. Even if foreign investors matter, they don't matter for all firms.

    ii) Even where foreign investment is high, shareholder activism by foreign investors faces serious limits (Osano). For example, coordination problems still exist for various institutional investors to jointly target pressure on particular company policies or poor management. Voting at shareholder meetings may be sporadic. And the low level of commitment to particular firms means that investors will ultimately favor exit beyond some threshold of performance. Moreover, social or cultural taboos exist that may make foreign investors reluctant to strongly target particular firms and be seen as "bad guys" within Japan.

    iii) While foreign investors may push for governance reform, countervailing pressures may also exist. To the extent that firms maintain main bank relationships or uphold cross-shareholding arrangements, firms may be less likely to abandon traditional corporate governance practices or to engage in corporate restructuring.

    c) Remaining Issues:

    i) New activism by domestic institutional investors? Pension fund activism, by U.S. and British funds in particular, has set a positive example for Japanese funds. The Pension Fund Association (PFA) has issued guidelines on the exercise of voting rights at annual general meetings of shareholders that stress the promotion of outside directors or issuing no-votes if a company shows sustained poor performance. As a result, the number of negative votes is dramatically increasing. It remains to be seen whether other domestic institutional investors will pick up on these trends. However, the portfolio of domestic investors is much broader than that of foreign investors and may thereby help to target pressure on smaller, domestically-oriented companies.

    ii) Hostile takeovers. Changes in the composition of shareholding (Miyajima) and (to some extent) the attitudes of investors may increase the prospect of a market for corporate control through hostile takeovers in Japan (Osano). Foreign investors are much more likely to support hostile bids that bring share price premiums, and the pressure of foreign investors on large Japanese industrials may also prompt them to rethink "stable shareholding" if target companies are performing poorly. Little research has been done on recent takeover attempts, as well as on the phenomenon of hostile stake-building (whereby large blockholders exit from control). A market for corporate control would have a huge impact on Japanese firms by greatly increasing shareholder pressure. The social science evidence on takeovers, however, remains very mixed. A "bright side" of takeovers is greater returns for target firm shareholders, whereas the "dark side" involves issues such as breach of trust and "short-termism." Further research is necessary to evaluate the prospects of M&A in Japan.

    iii) Targeted activism by foreign institutional investors? Differences exist in the type of shareholder activism pursued by foreign investors. Some institutions such as CalPERS are well known for targeting management at particular firms, as well as being very vocal about corporate governance principles. However, relatively few institutional investors follow such an activist model. An interesting issue will emerge in the future as to whether greater legal assertion of fiduciary duties in the U.S. or Europe may impact Japan by extending the scope of activism among existing foreign investors.

    4) Will the legal reforms aimed at boards of directors and statutory auditors strengthen external monitoring in Japanese corporations?

    a) Pro Viewpoint : Japanese boards are becoming smaller, more transparent and have a greater balance of outsiders with opinions different from that of the CEO.

    i) Legal changes to boards of directors have significantly upgraded the monitoring role played by outsiders. The main mandatory changes involve strengthening the independence of statutory auditors (kansayaku) by requiring at least two to be genuine outsiders (not ex-employees) as of mid-2005.

    ii) Another major reform facilitates the voluntary adoption of a board structure based on the so-called committee system. Here firms can opt out of the statutory auditor system by adopting a board with a majority of outside directors on three committees: the audit, nomination and remuneration committees. In the first year since its implementation, 55 companies have adopted this system (Shishido). Many of these firms are affiliate firms with outside directors from parent firms. In these cases, adoption does not seem to aim at promoting independent monitoring, but may have beneficial effects in terms of consolidating control within company groups.

    iii) The so-called executive officer system has become widespread in Japan. This system is associated with substantial reductions in the overall size of the board, the streamlining of decision-making and greater separation between the formulation of overall corporate strategy and implementation of business strategy at the operational level (Miyajima).

    iv) Available empirical evidence suggests that corporate disclosure is positively associated with higher performance among Japanese companies (Miyajima). This effect may be explained by either the lower capital costs associated with transparency, or the commitment effect on management to produce higher returns. Alternatively, the causation may be reversed, such that high-performing firms opt for greater transparency and disclosure.

    b) Con Viewpoint : Under the current legal rules, outsiders are unlikely to play a role as effective monitors of top management.

    i) Recent empirical studies on Japan suggest the introduction of the executive officer system or outside directors has not improved corporate performance (Miyajima). The reasons for this negligible effect remain unclear and lead to additional hypotheses. First, the positive effect of board reform may be contingent on the type of business. The separation of functions within the board may be beneficial for large organizations with very diversified businesses, but less well suited to single-product firms with an integrated organizational architecture. Second, outsiders may not yet be sufficiently independent to have the expected positive effect on corporate governance. Third, outside directors may have a positive impact, but these reforms are not chosen by the poorly performing firms that need them.

    ii) Under the reformed statutory auditor system, outsiders lack sufficient power to act as an effective monitor. The statutory auditor still has no legal power to sanction decisions made by the board, quite unlike German supervisory boards. Outside auditors are also appointed by the president, and thus even if they are outsiders, their degree of independence is questionable.

    iii) Under the committee system, many similar issues exist regarding the authority of outsiders within the board and their potential independence (Yanai). In theory, the committee system delegates important decisions to committees with outsider majorities and thus represents an important element of checks and balances. However, formal structures often tell little about the informal norms and culture of actual decision-making within a company. In addition, since the adoption of this system remains voluntary; the companies in greatest need of increased scrutiny and monitoring by outsiders may be the least likely to choose this form. This self-selection bias represents a serious limit on the policy approach of enabling reform rather than enacting mandatory legislation.

    iv) A related issue concerns the notion of independence. In legal terms, the recent Commercial Code amendments do not clearly define the notion of outsiders, apart from being a person who is not a current or former employee of the firm (Shishido, Yanai). This cautious approach has advantages in terms of avoiding imposing inflexible bureaucratic criteria, thus allowing scope for experimentation, and drawing in potentially diverse groups of people to serve as outside directors. But criteria assuring the independence of outsiders remain underdeveloped and may undermine positive governance functions to the extent that outside directors are "captured" by the president.

    c) Remaining Issues:

    i) Lack of social science evidence. Despite the extensive debate and discussion on the structure of boards and the role of outside directors, social science evidence on the effectiveness of outside directors is scant. Studies of Japanese firms remain quite rare, but do not seem to demonstrate any strong positive effects on corporate performance. Likewise, international studies using U.S. or British data seem rather inconclusive in terms of overall corporate performance. This may have to do, in part, with issues of endogeneity. Poor performance may trigger the introduction of outside directors. Or in countries with mandatory outsider boards, variance across firms may be small. However, a more extensive and systematic evaluation of this evidence would be highly desirable. Moreover, the introduction of outsiders in Japan remains at the early stages and the effects of the new committee system on performance must be studied in the near future.

    ii) In promoting effective outside directors, a major issue concerns expertise (Yanai). Directors must be sufficiently informed of the internal operations of the firm, the industry environment, and the like to effectively monitor strategic management decisions or outsiders must bring strategically relevant outside information.

    iii) A second issue for outside directors concerns the balance between representation and independence. To the degree that outsiders don't directly represent a stakeholder (investors, employees, banks, etc.), they remain vulnerable to capture by the president. When outsiders thus effectively represent important stakes in the firm, outsiders may be more likely to challenge top managers and may have sources of private information independent of the board. These features may help catalyze the monitoring functions of the board. On the other hand, it is sometimes argued that strong representation of stakeholder interests plagues the board with special interests and thus makes it incapable of making tough decisions. Empirically, this remains an open question. For example, German supervisory boards represent multiple stakeholder constituencies, but seem able to make decisions effectively.

    iv) More specifically, who might act as outside directors? Given the coordination problems on the investor side, it is doubtful whether investors will actively propose their own representatives as candidates for outside board positions in the near future (Yanai). Banks continue to send an outside director in the event of corporate financial distress. However, Japanese rules make no provision for employee representatives among outsiders, unlike countries such as Germany. Thus, it seems likely that outside directors will largely be drawn from managers of other companies.

    v) Outside directors may play not only a monitoring role, but also a resource role. Outside directors are often selected on the basis of their expertise in areas strategically important to the business. Here outsiders may be important brokers in the flow of information with business partners, competitors, and other intermediaries.

    vi) Enabling versus mandatory law. The discussion above indicated various trade-offs between an enabling approach, allowing choice of the structural forms, and a mandatory approach that imposes structural reform on Japanese companies (Shishido). Given that different board structures may be effective for different sorts of firms (no one size fits all), an enabling approach has merits. It may also eliminate the scope of policy failure, where mandatory rules inhibit the development of more effective practices. On the other hand, the main weakness of the enabling approach is its inability to "push" reform in companies that need it. Incremental local experimentation may not be sufficient to move toward new efficient sets of corporate governance practices and therefore a coordinated search may be preferable (Itoh). Existing managers of poorly performing firms may remain unlikely to voluntarily delegate authority to outsiders. Recent experience in the UK and Germany suggest that a soft-law approach based on voluntary codes and "comply-or-explain" principles may be a useful intermediary approach.

    vii) To what extent will the new committee system spread quickly in Japan? By most counts, some 55 firms have adopted the committee system. Some observers see this as more than expected, but the number does not suggest any quick paradigmatic shift to the new system. Some exploratory observations suggest that firms may have a variety of motives for adopting the committee system, particularly for the governance of group companies, or where outside directors are perceived as playing important resource roles. For other firms, shareholder pressure is insufficient to force adoption.

    Meanwhile, the new system has at least perceived disadvantages since many managers fail to see the benefits of outsiders, or feel this structure is inappropriate in industries where operational management is tightly integrated through horizontal information-sharing. Future research is needed to better understand the various motives of companies in adopting or not adopting this system.

    viii) What kind of relationship should major blue-chip manufacturing companies that have a wealth of internal financial resources have with external governance structures? Some very large Japanese companies have moved to self-financing, as well as becoming very large and diversified in terms of operations. In these companies, the principle-agent problem manifests itself rather differently. Agency problems may be acute within the firm, such as between the headquarters and various divisions or subsidiary firms. Moreover, external finance does not act as a source of external discipline. Put another way, such firms approximate the Berle-Means type of "managerial controlled" firm that is financially autonomous and without controlling owners. Greater consideration should be given to whether the appropriate checks and balances among stakeholders depend on the type of financing.

    5) To what extent can corporate governance in Japan be said to be converging on the U.S. model? What do recent changes suggest about the complementarities between different elements of the Japanese corporate governance system?

    a) Pro Viewpoint : Japan is converging toward a US-style of corporate governance based on a shareholder orientation.

    i) A variety of evidence based on firm-level analysis suggests that exposure of Japanese firms to capital market pressure is strongly associated with the adoption of many elements of a U.S.-style shareholder-oriented corporate governance (Jackson). Bond finance and foreign ownership are associated with increasing transparency and reforms in boards of directors (Miyajima). Some evidence also suggests capital market pressures lead to adjustments in employment levels (Abe, Ahmadjian). These movements toward outsider control and greater transparency all point in the direction of substantial change toward a U.S. corporate governance paradigm.

    ii) Other key elements of the Japanese system have eroded, such as the main bank relationship and cross-shareholding (Miyajima). While the extent of this erosion can be debated empirically, these trends suggest the declining influence of past institutions and a paradigm shift toward new forms of governance.

    iii) Legal reforms have now given Japanese firms the option to adopt a U.S.-style system for the board of directors. This enabling legislation can be seen as a trend toward a formal convergence between Japanese and U.S. corporate law (Shishido).

    iv) One reason for this erosion is that elements of market-based and relation-based corporate governance systems may be incompatible with existing institutional infrastructures based on legal systems or institutional design (Teranishi). For example, the liberalization of capital markets makes it impossible to sustain purely bank-based corporate governance arrangements in their past forms. Capital markets mandate transparency on the basis of public information disclosure, unlike relational systems that center on the informational rents of long-term relationships. Likewise, greater orientation toward shareholders interests may be incompatible with maintaining strong cooperation among stakeholders.

    b) Con Viewpoint : Japan will not converge on the U.S. model. Rather, Japan can develop an effective hybrid form of corporate governance that sustains competitive advantage based on some balance of shareholder and stakeholder orientation.

    i) Despite important changes, many empirical continuities can be observed within Japan. In terms of corporate ownership and finance, substantial heterogeneity exists within Japan (Jackson and Miyajima). While some firms have reduced ties to main banks, other firms have intensified them. Foreign investors also focus on rather select segments of firms. In terms of employees, the correlation between changes in ownership or governance and employment patterns is relatively weak (Abe). Lifetime employment has proven rather robust, while being modified only at the margin (Jackson). Thus, even where change is occurring, the results are new hybrid forms of corporate governance that combine different structural characteristics from the traditional U.S. and Japanese models.

    ii) Cluster analysis of corporate governance characteristics show that about 69% of listed firms still conform to the classic Japanese model of corporate governance characterized by keiretsu networks, main bank ties, little corporate governance reform, and traditional lifetime employment (Jackson). Another 17% are independent firms that do not belong to traditional keiretsu, but have made slow progress on corporate governance reform. Finally, about 14% of firms represent a hybrid model based on institutional ownership, market finance, and rapid corporate governance reform. However, even these firms maintain commitments to lifetime employment and vary in the degree of outsider involvement on the board.

    iii) In particular, Japanese firms have been very reluctant to abandon lifetime employment norms. About 80% of firms express continued commitment to lifetime employment (Miyajima, Jackson). Rather, Japanese firms have been actively restructuring their activities using benevolent forms of employment adjustment such as early retirement, transfers and the like. Outright layoffs remain extremely rare, and account for less than 5% of the overall reduction in employment (Jackson). Meanwhile, pay systems at Japanese companies are becoming more variable and performance oriented. But this seems to be a more marginal adjustment to the core role of human resources in Japanese firms.

    c) Remaining Issues:

    i) Are hybrid models really stable or simply a transition stage? Unfortunately, this question cannot be answered empirically (Jackson). However, extrapolation of current trends and rates of change can be misleading. For example, rapid rates of change in cross-shareholding may stabilize at lower levels given strong incentives not to completely abandon this practice. Other stable institutions may reach critical "tipping points" where the failure to adjust reaches a crisis magnitude. For example, lifetime employment practices have been adapted to corporate restructuring by the use of benevolent employment adjustment methods, such as early retirement, transfers and so on. But such adjustment processes may reach limits, and then be faced with collapse. The potentially non-linear dynamics of economic and institutional change are not well understood. In this sense, no empirical answer to this question can be expected.

    ii) The theoretical basis of "hybrid" models of corporate governance is not well understood (Itoh, Yanai). How should the interests of various stakeholders be balanced in practice? Most economic theories stress the negative-sum relationships between shareholders and employees in terms of distributional outcomes. However, the positive-sum relationships between corporate governance and stakeholder voice have been seriously neglected (Jackson). The development of a "negotiated" form of shareholder-value may serve as a form of checks-and-balances against short-termism or myopic signals from investors. Likewise, investors and employees may share a common interest in promoting greater transparency in the decision-making and accountability of top managers. Empirical evidence suggests that strong stakeholder voice may increase responsiveness to competitive pressures and adoption of corporate governance reforms, rather than slow them (Miyajima).

    iii) A large segment of Japanese firms are still in need of corporate governance reform. About 50% of firms in Japan still follow a very traditional model of corporate governance, and these firms have been reluctant to engage in corporate governance reform (Miyajima and Jackson). This group includes many poorly performing firms most in need of more active monitoring, such as firms locked into nonperforming loans with banks. As noted above, the enabling approach to legal reform has not been sufficient to induce these companies to undertake substantial reform. Several potential candidates may emerge to generate more intensive monitoring. First, a growing market for corporate control may exert external discipline on these firms, but M&A also carries many downside risks. Second, a greater use of soft-law instruments and establishing codes of corporate governance would help to reinforce the role of outsiders within the board and facilitate greater investor activism through greater transparency. Third, over time, domestic mutual funds will become more active and will intensify pressures on these companies. Fourth, European models with greater formal rights for existing stakeholders may strengthen accountability of management in poorly performing firms.

    iv) The relationship between firms' organizational architecture (integral-modular) and corporate governance. The theory of comparative institutional advantage posits that different institutions will be advantageous for different types of economic activity. Thus, nations may choose to specialize in industries that fit well to historically given institutional traits. However, firms may also be able to choose governance characteristics to match their organizational architecture and given sector. This relationship has important implications for Japan, where regulatory reforms and economic trends are leading to greater diversity of corporate governance traits across firms. Here a future research agenda would be very useful to explore empirically the complementarities between corporate governance and organizational architectures using firm-level data.

    6) Other General Issues

    a) Relationship between skill formation and corporate governance. A growing literature now links corporate governance with issues of skill formation. One aspect concerns their mutual link to patterns of innovation. For example, incremental innovations thrive under conditions of strong firm-specific skills and stable, relational financing. Another aspect concerns the direct linkage between corporate governance and skill formation and retention. Market-oriented corporate governance characterized by investor pressures and high M&A activity may lead to the erosion of firm-specific human capital, or may even preclude such investments. Meanwhile, firm-specific skills are supported in the context of long-term investment and stakeholder voice in corporate governance. As noted above, this link suggests broader implications for corporate governance in terms of business strategy and performance to be explored in future research.

    b) What kind of the theoretical framework is effective for understanding change in the Japanese corporate system? Hybrid models raise the theoretical issue of understanding the complementarities between different institutional or organizational elements. The literature on complementarities suggests that the positive role of an institution may depend on the presence or absence of complementary institutions. This systemic perspective has been usefully applied to understanding differences between Japan and the United States. However, these concepts must be refined to better understand the tradeoffs or potential viability of "mixed" forms of corporate governance. Such mixed forms may combine elements of best practice, or they may be incoherent.

    c) A useful theoretical distinction may be made between complementarity and compatibility between institutions. Some governance practices may, in fact, be compatible with a variety of other institutional arrangements. Legal rules may be ambiguous and allow for reinterpretation in new ways that fit with shifting environments. And old institutions can take on new functions. Moreover, choices over what sets of characteristics firms should adopt may be contingent on industry-specific or even company-specific parameters: Assume that A1 and B1 may be complementary, as well as A2 and B2. This does not rule out that A1 and B2 may be complementary under different exogenous conditions.

    d) The role of the management under the complicated interests of shareholder and stakeholder (Itoh). Most economic theory assumes that firms have single, objective functions such as shareholder returns and that if firms have multiple objective functions such as balancing shareholder and stakeholder interests, accountability of decision-making will suffer. Theories from sociology and organizational behavior, by contrast, posit that multiple objectives are the rule rather than the exception. However, these sorts of objective functions have not been systematically explored in terms of formal models.

    e) Assessment of current U.S. policy following the Enron case, including the Sarbanes-Oxley Act (its historical significance, and its relationship with the A-model). Much debate on corporate governance still draws upon a rather stylized vision of the U.S. model. As shown by Sorbanes-Oxley, this model is in a high state of flux. The role of outside directors continues to evolve. Accounting, compliance and other internal monitoring issues have now come to the fore. U.S. rules often have extraterritorial legal application to Japanese firms listed in the U.S. But beyond that, an evaluation of recent developments in the U.S. is key to informing a forward-looking policy in Japan.


    Edited by Gregory JACKSON, Visiting Fellow, RIETI / Senior Lecturer, Kings College London