Choice as Regulatory Reform: The Case of Japanese Corporate Governance

My talk today is based on a paper which was co-authored by a colleague in Columbia, Ronald Gilson. We are still early in this process of looking at the "iinkai to secchi gaisha," or companies that have moved to the committee system in Japan. After one year, we would like to try to take stock of what companies adopted the system, and what we can say very preliminarily about the future of Japanese corporate governance. What interests us most is the approach that Japan has taken towards corporate governance reform. In 2002, the Commercial Code was amended to allow Japanese companies to switch to so-called "U.S.-style board," which is different from the other board reforms that took place after major financial crises in the U.S., Taiwan and Korea. But that was a mandatory blanket reform for all large companies.

Japan, on the other hand, provided an option for firms. In this paper we tried to make a list of all the companies that adopted the committee system in the first year, or the task route of shareholder meetings. We identified the characteristics of those firms and their strategies. Why would a Japanese company adopt the committee system and abandon the "kansayaku," or corporate auditor system? We did some statistical tests and event studies on these firms, to see the way the market reacted to these adoptions. Then we tried to think about what we might say about the future of the direction of Japanese corporate governance. Putting this reform into context, the choice option of the committee system was the capstone over the last ten years of reform in Japan. Two things we can deduce is the extent of the corporate law reform over the past decade with the remarkable amount of corporate law reform, and the increasing pace of reform.

The Commercial Code used to be amended every few years, but into the 2000s the Code was being amended multiple times in a single year. Two strains can be drawn out of these amendments. One is a flexibility-enhancing amendment, giving Japanese managers more organizational flexibility. The second strain is monitoring-enhancing amendments. From that perspective, this choice of reform in the creation of the committee system can be seen as capturing both trends: giving Japanese firms greater options and a real attempt to improve the board as a monitoring organization.

Professor Shishido suggested that many corporate law reforms were "policy push," bureaucratically initiated without concern for what is needed in the marketplace. He suggested there has been a fundamental change for more demand-pulled amendments over time with more input from the private sector into the amendment process. The impetus for that came from the business community when they lobbied the government directly because of the lack of time to go through the process of corporate governance amendments. Since then the production of Japanese law has become more competitive, with much more input from nontraditional sources. This is important toward the 2002 reform, providing the committee system option, because in many ways this reform was compromised between traditional thinking and other progressive or Western thinking about corporate governance. It is the capstone of the political dynamic in the mid 1990s.

As of April last year, large firms can either stick with the kansayaku system or adopt the board committee system. Companies that adopt the committee system must have committees for audit nomination and compensation, and each committee must have a majority of outside directors. The definition of "outside director" is broad enough to encompass director assent from a parent company, or major shareholder, contrasting with "independent director" used in post-Enron U.S., where "independent" is used very strictly and with high levels of scrutiny. This is a major area of divergence between the outward movement toward the U.S. system in Japan, and the actual U.S. system today.

Seventy-one firms in total have adopted the system, or 45 out of 3,000 listed firms. The number is not high, but more than predicted. These firms break into two groups: Hitachi-group firms and Nomura-firms, which make up 36 firms, and 35 firms outside. The types of firms which adopted the system can be divided into several categories: global market players, firms with a high percentage of foreign shareholding, a number of distressed firms, some firms acquired due to strategic global expansion. The Hitachi and Nomura group-firms are not group firms in the traditional "keiretsu" sense, so from an outsider's perspective, it was surprising to see other group firms adopting this system.

Another surprising point for the American perspective is that of the Japanese firms that adopted the committee system, only four have shares cross-listed on an American stock exchange. It would have been predicted that the firms adopting the new board structures would be trying to appeal to American shareholders. Possible explanations include the Sarbanes-Oxley Act, which ironically provides an incentive for Japanese firms not to adopt. If a firm is listed on the American stock exchange, it must have an audit committee composed exclusively of independent directors. However, foreign firms under different structures can stay with their current systems. Only one member on the board must be independent, so it may be easier for firms to stay with their systems.

The second reason is the way that many Japanese firms are listed in the U.S. There are different ways that foreign firms can be listed. One is the Level III ADR, which for all practical purposes is seen as an American company by an investor and these firms have nothing to gain by changing systems. Seven Japanese companies are listed through Level III ADR. Only Hitachi adopted the committee system, but for different reasons.

There are four possible strategies to think why a Japanese firm would adopt the committee system. The first is the signaling or bonding story, to signal its adherence to "good" corporate governance. However, there is no support for this. In systems like Korea, there is a problem with "shareholder tunneling," where majority shareholders are ripping off the minority shareholders. There independent directors do improve firm value by signaling to minority shareholders that the investment is safe. Japan does not have this problem, but we believe Japan has a related corporate governance problem, "stakeholder tunneling" or the diversion of shareholder wealth to other constituencies. Outside directors with different cultural mindsets could be effective in dealing with this.

The second reason why firms might adopt the committee system is endogeneity, which argues that corporate structures will vary depending on the needs of a given firm. Similarly, Japanese firms could switch or not switch depending on their own requirements. There is some support for this concerning adoption. The largest concentration of adoption is in the electronics industry, troubled industries, and firms with a high percentage of foreign shareholders.

The third motivation is group control. The option that the committee system can use is to not only adopt the "U.S.-style board structure," but to reinforce "Japanese group structures," which was the motivation of Hitachi and Nomura for adoption. They wanted to bring greater parent control to the group and this was made possible by the expansive definition of "outside director," which encompasses directors from parent companies. So when looking at the boards, there is a clear bifurcation. Group firms have outside directors, or directors affiliated with a parent firm, but nongroup firms have truly independent directors and a much lower percentage have actual business ties.

The final phenomenon is indeterminacy. There is no overriding pattern in motivation visible in these adoptions. From a political economy perspective, there was controversy on adopting the U.S. system and thus the choice of option was an institutional compromise.

We ran some event studies on the stock market's reaction to the announcement by these companies that they would adopt the committee system. Looking at 22 companies that were not Hitachi-affiliates, there was no significant stock market reaction. The move had been publicly predicted for some firms and so perhaps there was a bigger reaction to the more domestically-oriented firms. The study was thus divided into two subsamples: a "domestic" subsample and the more "international" firms operating in global markets. However, there were still no statistically significant stock price effects.

Finally, each company was checked for the stock market's reaction to their individual announcements. There was a statistically significant reaction to only three firms: Ichiyoshi, Toyama and Resona Holdings. We do not understand why the market went down for Ichiyoshi and Toyama. However, the market reacted very positively for Resona Holdings at a 99% confidence level. We believe that the market took this as a signal that the FSA was serious about cleaning up Resona. What was more significant was the statement that the FSA cared about improving corporate governance in Resona, or perhaps the market just interpreted this as a signal that the FSA was serious about cleaning up the troubled banking sector.

Hence, this is a good example of formal, but not functional, convergence. In formal convergence, a company or country adopts the laws of another but it may have little impact because of functional institutions. Japan may have adopted the U.S. board system, but not the complementary institutions that make it function as it would in the U.S.

The missing complementarity could be judicial review. Japan does not have a strong tradition of judicial review of corporate transactions, unlike the U.S., and the impetus for using outside directors originally came from judicial review. One potential problem is a negative impact on corporate law. Japanese courts could simply agree with a corporate decision because "outside committee," had approved the transaction, without looking at whether or not those directors were truly independent. The "keidanren's" recommendations on special litigation committees in derivative litigation mischaracterized the way Delaware courts handle the recommendations of special litigation committees. They imply that having an outside committee means that the courts do not have to be involved when Delaware courts scrutinize carefully whether a committee is independent. Therefore, this could be misused in Japan.

The U.S. and Japan may be moving in different directions in corporate governance reform. Japan has adopted an enabling approach towards board reform, choice option. Companies are free to take whatever choices they want subject to judicial review exposed and this is clearly Japan's motivation. However, the U.S. is moving towards a more mandatory system in corporate governance. It is only in a limited set of areas, but this could be a negative precedent for U.S. corporate law. U.S. listing standards are ratcheting up the scrutiny of board independence, while Japan has adopted an outside director system and looser definition of outside director. In some ways then, we are seeing opposite directions. This choice approach does not imply that Japan itself is moving towards a single new system of J-Form corporate governance, but the opposite: bifurcation between Japanese firms and global firms. There may be continued institutional diversity and ideological diversity in Japan, facilitated by this option.

Q: Why do so few companies have a committee structure? One explanation is that Japanese CEOs do not like to relinquish their ability to appoint their successor. A committee structure may not allow them to keep that power. One line of thinking is that they are badly paid and therefore want some influence in the company even after their departure. So the committee structure may not work unless some other things happen simultaneously. There is a need for a managers' market, which permits the committee to find someone outside the company, but there is no such thing happening currently.

A: That makes sense to me. There seems to be hesitancy in appointing outside directors because of a lack of tradition. I have also heard that the board cannot do much if you delegate the imported functions to these three committees. If you do not have a strong tradition of the board as a strategic decision-making unit, it could be a potential danger.

Q: I am always a little bit concerned when people talk about corporate governance and immediately start looking for some pattern of return from good and bad corporate governance companies. Maybe corporate governance is more useful than the investment perspective by measuring the risk within a portfolio. Do you think that is sensible from the investment perspective and do you know any work done in that area?

A: Have some people not tried that with respect to transition in economies? What sort of premium would you pay if you no longer had to worry? In the Korean case, your investment would be mishandled by the dominant shareholders, so there are people who are approaching corporate governance from that perspective. I have seen it only with transitional economies, so I think it is a promising different angle. There is not a strong linkage shown in studies between corporate governance and firm performance. Maybe there are some deeper questions we have to get to, so I agree in this aspect.

Q: You used the words "shareholder tunneling," "stakeholder tunneling." I think the major difference between Korea, the U.S. and Japan is that in both the U.S. and Korea, people have clear ideas of the abuses they are trying to correct. Is the court's emphasis on the independence of external directors recent? I was reminded of RJR Nabisco, with the fuss over the appointment of so-called independent directors. Does it date from that?

A: Yes, mostly from the 80s when the courts said, "Set this up like an arms-length transaction. We can then give you a break in our analysis of the transaction."

Q: It seems in Japan the motives to change were not similarly perceived as abuses to be corrected. There was the sense that the Japanese macroeconomy was not performing well due to microeconomic deficiencies. One was the abuse of "fushoji," but not of the same nature as U.S. management tunneling. The second abuse was transparency, as in the Yamaichi case where people falsified accounts to keep the firm in existence. The media, emphasizing something wrong with corporate governance, made people convinced of the superiority of American capitalism as a charter for reform. The result is this paradoxical thing that allows management to reinforce its closed nature. I doubt whether the ability to choose one's successor has a financial incentive, and it makes the absence of external constraints much less serious in Japan. Management tunneling is a problem, but not employee tunneling because if managers regard the employees' welfare highly, it can be socially better and more efficient in hard times.

A: You said that the paradox of the system can be used to reinforce the autonomy of managers, but most of the reforms made in the past decade have that quality. Giving management great autonomy is generally a good thing but can be used in different ways, and one is to perpetuate themselves in office. On employee tunneling, you made a good point that within these scandals, the actual target is different in different countries. In certain environments, the emphasis on employee welfare may be efficient and beneficial but whether that environment still exists in Japan, that is a big debate.

Q: Why do you need outside directors? It worked for Korean companies because of shareholder tunneling, but in Japan there is no such problem. The concept of a company community is very strong and so far shareholders have never intervened. After the war, most public company community members enjoyed total authority without outsiders. But now, the Japanese shareholders have recognized that monitoring is necessary. We are still thinking of whether only a few outside directors would be efficient or not.

On the surface, recommendation is not mandatory, but from the perspective of the company community, it was. Now Japanese companies must choose some outsiders, and from this stance the definition of "independent" almost means nothing. The real problem is whether the outsider is a company community member or not. In that sense, it is mandatory from a community point of view. They need to accept a clear outsider.

A: Why would someone affiliated with a parent firm be an outsider to the company community concept?

Q: Parent-subsidiary relationships are not the same as in the U.S. In Japan, even 100% subsidiaries organize their own communities. For the company community members of the subsidiary, the parent company is an outsider for them. This would be the next step for corporate law reformation in Japan, but it is not that big of a problem now.

Q: There were various studies done on the possible link between corporate performance and governance, but how much do companies pay attention to these studies? Do they genuinely believe it will make a difference?

A: There are firms that think it is right to adopt this system, as it is understandable to the outside world, and more transparent. That is one of the reasons why the FSA adopted it. The paper says if you look at the reasons for adoption, there may be less here than meets the eye, which the market believed as well. Maybe we are looking for the wrong type of linkage here. Not firm performance, but avoiding scandals or giving investors confidence. There are bigger unanswered questions, but it is not all meaningless.

Q: When senior managers of a big corporation become directors, they view that as a promotion, and not as a responsibility. This shows a lack of awareness of the functions of the board of directors. Japanese businesspeople do not understand that the board of directors is different from management. What will bringing in outside directors do when the board is controlled by insiders who feel that being on the board is a promotion?

A: It goes back to the definition of outside director. If committees are staffed with directors affiliated with parent companies or such, then there will not be much difference. But truly independent members would make a difference if they are actually functioning. Perhaps one benefit is thinking about the actual function of the board.

Q: Even if there is only one outsider on the board, the CEO would have to explain matters. It would make a difference as the first step towards good corporate governance.

Q: With respect to transparency and risk management, have rating agencies reacted to changes in the governance structure? This would be important because the banks would be pressed to look at the reactions of the rating agencies. This would have a major impact on Japan because stock markets are still not all there.

A: I have not checked the rating agencies' reactions. I do not know what we would expect to find given the stock market reaction. Perhaps they look at them differently.

Q: Is it healthy to have two systems domestically? Internationally it seems to be healthier to have diversity, but what about domestically?

A: My sense is that it would be healthy. It is hard to see the disadvantage of competition, which was the impetus for this route.

Q: Only well-respected companies seem to have traditional systems. The independent system may work for protecting minority interests but not for corporate performance.

A: In the U.S., regulatory competition is valued, as good ideas come out of competition between regulators by allowing systems to move out of restrictive systems. From this perspective it would be good for Japan. Could you explain the potential dangers?

Q: It is rare to have competitive domestic systems. Internationally, it has worked in many cases. Domestically we usually do not have competitive systems, but perhaps we do not have competition systems in corporate governance.

A: We have to see how it turns out. One potential danger is that a clear bifurcation would not develop in Japan between global companies and Japanese companies. It is not obvious how choice will play out as there are no clear patterns in the companies' choices, but no unhealthy things either. Maybe there are no particular benefits.

Q: Have you tried Tobin's Q to evaluate the adoption of committee systems? You also said that Japan lacks a legal environment that could support having outside and independent directors. But the U.K. has this system, even though in English law there are only a few rules that favor outside or independent directors.

A: We have not tried Tobin's Q but I do not think we will find anything. On the second point, it is misleading to talk about an Anglo-American model, as the differences in the corporate law systems are very large and many things are not explained.

Q: I do not understand the significance of the distinction between outside and independent directors. In the U.S., outside or independent directors are significant only in the case of publicly listed companies. What is your concept of a parent company? Why would it be significant if you had a wholly owned subsidiary that adopts a committee system which includes directors from the parent company? It seems to be the same.

A: But the subsidiary is not wholly listed.

Q: How much control does the parent have anyway?

A: Well, now it has more. That is the point.

Q: Without the committee system in other words, they would not have it?

A: Not necessarily, but this is one additional mechanism control, and it seems to be an outcome of the committee system that could be put to those purposes. It may or may not be a good thing, but it is not a corporate governance reason.

Q: But the subsidiaries of a foreign company are totally controlled by that foreign company. There is no commonality or bifurcation of subsidiaries in Japan.

A: If you look at the wholeness of a subsidiary, or if you have groups of firms where there are low levels of share ownership by the parent company, that is quite significant.

Q: Outside directors can have good influence on decision-making. It can happen and not just be in the shareholder's interests. I think it is true that being appointed to director still seems to be a promotion and historically people on the board saw themselves as owners. Toyota has also just revamped its structure, but Toyota is so big that all people have certain levels of acceptance on the board. The notion that there are separable functions is rejected at Toyota.

A: Well, Toyota is the counterexample that has been successful.

Q: Sony has an outside director for resource dependency. As they depend on financial markets, they want information which is outside their expertise. Is this endogeneity? Secondly, there were always outside directors at Japanese companies. Rather than involving the committee system wholeheartedly they have outsiders on their boards on some committees. What about this very large number of companies in the gray zone?

A: You are right. The notion of directors as monitors is too simplistic. They create business opportunities and other resource dependency as leaders. The endogeneity category puts things in boxes but we must look deeper. What kind of hybrid system does this allow? With the kansayaku system you can have an asset committee to determine certain things but can you delegate other authorities in other committees?

Q: You can set up any informal committee if you like. The board has to decide again, formally. Some people are discussing how to deregulate the committee system. One idea is if you have the majority outside, you can choose any committees other than that.

A: So we will see another round of reforms following on this.