As part of the government's growth strategy, the future shape of corporate governance in Japan is coming under intense debate. Since the eruption of Japan's banking crisis in 1997, corporate governance reform has been one of the central issues in policy debate. However, what we see today could be defined as the second major peak following the first one around the time of the 2002 amendment of the Companies Act that introduced "companies with committees" as an optional form of corporate structure. The ongoing discussion, which started in the fall of 2011 with a debate on the pros and cons of a proposed amendment to the Companies Act that called for mandating the appointment of an outside director, was given greater significance in June 2013 when the enhancement of corporate governance was defined as one of the key policy measures under the government's Japan Revitalization Strategy. Reform initiatives toward enhancing internal control, including the reform of boards of directors, were put into a systematic form when they were presented in a package with measures for enhancing external control such as the Japan's Stewardship Code (Note 1). Furthermore, with a new series of discussion launched in September 2013 for the establishment of a corporate governance code, efforts are now underway to put together basic ideas concerning the type of governance structure to be pursued in the future and present them in the form of principles. This article aims to explore possible directions for future corporate governance reform in Japan.
Challenges in the reform of governance structure
The ownership structure of Japanese companies has changed drastically following the banking crisis in the late 1990s. Cross-shareholdings among closely-related Japanese companies were unbundled, whereas institutional ownership has increased sharply over the years. The percentage of shares held by Japanese and foreign institutional investors in the companies listed on the Tokyo Stock Exchange (TSE) increased from 23% in 1996 to 48% in 2013. As shown in Figure 1, ownership by "outsiders," which combines institutional investors and individual investors, has been on the rise and is nearing 60%. Throughout those years, the number of listed companies steadily increased in Japan, which is in stark contrast to an emerging trend of public companies going private in the United Kingdom and the United States, a fact that has drawn little attention. Meanwhile, the combined total percentage of shares held by "insiders," such as business corporations, creditor banks, and life insurers, is still as high as 40%, and each of them remains a blockholder owning a sizable percentage of shares in each investee company, in marked contrast to the widely dispersed ownership among Japanese and foreign institutional investors despite the significant rise in their combined ownership. In other words, Japanese companies typically enjoy the benefits of being listed on a stock exchange, maintain a stable ownership structure, and accept an increase in shareholding by institutional investors. This developmental path is markedly different from the one observed in the United States and the United Kingdom, where institutional investors have an overwhelming presence as shareholders but the number of listed companies is decreasing, or that in continental Europe, where the number of listed companies is limited and founding family-controlled companies are a common form of ownership.
Therefore, corporate governance problems that Japanese firms faced are quite different from those faced by their U.S. and UK counterparts or those in continental Europe. Problems with continental European companies lie in the conflict of interest between founding families and companies. Meanwhile, as pointed out in the Kay Review of UK Equity Markets and Long-Term Decision Making, post-Lehman danger to joint stock companies in the United Kingdom and the United States stems from the change in the nature of equity markets that has turned them into a mechanism for short-term-oriented shareholders to expropriate rents from other stakeholders such as creditors and employees through hostile takeovers or by forcing corporate managers to take excessive risks. In contrast, the problem with Japanese companies is that the controlling power of external shareholders still remains weak, resulting in the prevalent behavior of risk aversion and conservatism among corporate managers, excessive cash hoarding, and the delivery of low returns to shareholders. Accordingly, the desirable direction of Japan's corporate governance reform is to redefine the balance between benefits to shareholders and those to other stakeholders in favor of the former, in particular, external shareholders (investors), while maintaining certain unique features of Japanese companies such as long-term shareholding and employees' commitment to their companies.
What will change with the Stewardship Code?
Japan's Stewardship Code, published in February 2014, will serve as an important momentum builder for rebalancing in favor of shareholders as investors enhance their monitoring of investee companies. But then, what changes will it bring and through what channels?
First, the Stewardship Code (hereinafter the "Code") calls on institutional investors to set a clear investment policy (Principles 1 and 7). This has a significant impact particularly on asset owners (pension funds), as investment advisory companies have already been disclosing their asset management policies as well as voting policies and records. A number of asset owners—i.e., public and private pension funds including the Government Pension Investment Fund (GPIF)—have signed up for the Code. This means that they have committed themselves to specifying policies for the selection and evaluation of asset management firms and evaluating their performance. Such commitment will work to increase asset owners' accountability to ultimate beneficiaries (pensioners, the general public, corporate employees). At the same time, it will be relevant also for those ultimate beneficiaries to monitor asset owners more actively with respect to their selection of asset management firms. Through the formation of such an investment chain, the Code facilitates asset management firms' efforts to improve their dialogue with investee companies.
Second, the Code calls on asset management firms to identify and manage the conflicts of interest facing them (Principle 2). It has been pointed out that Japanese institutional investors—whether asset management firms, insurance companies, or trust banks—could be influenced by their parent or other group companies in selecting target companies for investment and/or exercising voting rights. With this principle, the Code requires that institutional investors address this problem explicitly. However, since our analysis (Note 2) found no strong biases in the investment behavior of Japanese asset management firms, life insurance companies are just the ones that are likely to feel a significant impact. Indeed, Japanese life insurance companies have often been called "gray institutions" because of the possibility of their giving consideration to other transactions—an expansion in sales of insurance policies—in making investment decisions and exercising voting rights. In this respect, it is a welcome development that Japanese life insurance companies have signed up for the Code, which can be considered as one of the most important effects of the Code. On August 13, 2014, Dai-ichi Life Insurance Co., Ltd. decided to disclose its voting record, becoming the first Japanese life insurer to make such decision (the voting record was disclosed on August 26, 2014). In a simple event study, I examined the market reactions to this disclosure with Ryo Ogawa, a research assistant at RIETI and a doctoral candidate at the Graduate School of Commerce, Waseda University. The cumulative abnormal return on companies for which Dai-ichi Life Insurance is among the top 10 shareholders (178 out of a total of 1,802 companies listed on the first section of the TSE) from August 13-14, 2014 was significantly positive (0.27%). This contrasts with the fact that the stock prices of those companies for which Nippon Life Insurance Company is among the top 10 shareholders showed no reaction. It is expected that the Code will prompt Japanese life insurance companies, which have long been regarded as silent shareholders, to become more actively involved in the governance of investee companies.
Third, active dialogue between companies and the stock market, which is called for by Principles 3 and 4, will gradually influence management decisions going forward. Matters to be considered in the dialogue are not operational decisions of investee companies but likely will include the following: 1) shareholder payout policy such as dividend distributions and share buybacks and cancellation, 2) financial policy (capital structure and financing), 3) business restructuring plan, 4) merger and acquisition (M&A) strategies, and 5) introduction of anti-takeover measures. With respect to those measures, it will become more important to obtain shareholders' approval, whereas any measure that is detrimental to or unlikely to increase shareholders' interest will become unsustainable. However, there is a danger that some companies may become overly concerned about shareholders' interest, giving rise to the following problems: 1) excessive dividends, 2) excessive debt financing, 3) sale of assets that are potentially valuable (from a long-term perspective), 4) excessive M&A, and 5) avoidance of necessary anti-takeover measures. This is what is referred to as the "negative side" of dialogue with the stock market, caused by information asymmetry and the short-termism of shareholders. However, my judgment at the moment is that the immediate problem facing most Japanese companies is the lack of sufficient influence of the stock market on business management, and that shareholders' short-termism is posing a serious problem only to a handful of companies with more than 60% held by institutional investors, and thus can and should be addressed in the future.
Lastly, the implementation of the Code, which calls for active dialogue between investors and investees, is expected to change investors' voting behavior, which is currently overly reliant on formality requirements, to one focusing more on substance, by promoting their better understanding of company-specific situations and circumstances. For investee companies, this will be an opportunity to deepen their understanding of what their investors are seeking. Furthermore, it is also expected that the implementation of the Code will enable Japanese companies to: 1) fully let investors know about their fundamental information on the value of their companies, and 2) resolve typical misunderstandings held by institutional investors who are unfamiliar with the circumstances in Japan. Foreign institutional investors are likely to appreciate firms that satisfy the formal criteria of the Anglo-Saxon model (e.g., outside directors, stock options) in selecting target companies for investment. However, not all Japanese companies need to follow the Anglo-Saxon model. Indeed, introducing such governance system could be harmful to some companies. Rather, it is becoming all the more important for each company to explicitly explain its selected corporate governance structure, for instance, in terms of its relationship with the characteristics of its business.
Scope of impact of the Stewardship Code
The greater stewardship responsibility of institutional investors required under the Code could boost shareholder value through the above-discussed channels. However, this would not necessarily improve the external governance of Japanese listed companies immediately. Let's take a look at things that should be noted.
First, we need to be aware that companies whose corporate governance can be influenced by institutional investors are limited. Figure 2 shows the simple average institutional ownership in listed companies in terms of market capitalization by quintile. As a comparison between this and Figure 1 indicates, the pattern of changes in the ownership structure obtained by a weighted average based on TSE market capitalization is observed only with those companies with large market capitalizations. Targets for overseas institutional investors are confined to large companies, particularly those included in the Morgan Stanley Capital International (MSCI) Japan index, and a market capitalization of 200 million yen is believed to be the lowest acceptable level for them. Accordingly, the impact of the Code in terms of promoting dialogue between investors and investees is effectively limited to around the top 350-400 companies in terms of market capitalization.
Needless to say, even in the case of relatively small companies that are not included in the MSCI Japan index, it is true that stock prices go up when they become targets for overseas institutional investors and their ownership has a positive impact on the performance of companies. However, there are only a limited number of such cases. Thus, as prerequisites for increasing the importance of institutional investors' monitoring as an element of corporate governance in Japan, institutional investors—Japanese ones in particular—need to expand their investment universe and increase investment in small-cap funds.
Promotion of long-term commitments
Second, even in terms of its impact on major companies that are targets for overseas institutional investors, the Code has intrinsic limitations in that it is designed to strengthen monitoring by means of enhanced dialogue between institutional investors and investees. In order for shareholders to have a suggestion in helping investee companies achieve sustainable growth, it is essential that they commit to long-term ownership. However, the basic business model of asset management firms is geared toward reducing risk through portfolio diversification and making no commitment to long-term ownership. In the case of institutions that are engaged primarily in active asset management with an average holding period of around one year, it is hard to expect any meaningful dialogue with investee companies for their medium to long term growth. Meanwhile, those managing index funds would have a limit to the cost that they can afford to pay for such dialogue. Furthermore, those overseas institutional investors that are investing or considering investing in the Japanese market as part of their internationally diversified portfolios are unlikely to be interested in holding such in-depth dialogue as addressing problems with management policies. As such, we must not expect too much from the Code as a vehicle to promote dialogue.
Thus, what is likely to happen in reality is the gradual development of constructive dialogue between investors and investees, and for that, long-term commitments on the part of investors are essential. In this regard, it is hoped that a greater variety of long-term, focused investment funds—those committed to long-term shareholding in a small number of companies—will be made available. It is also important that life insurance companies committed to long-term shareholding will gradually strengthen their function as activist shareholders. Furthermore, another potentially meaningful approach would be for a group of Japanese and/or foreign investors engaged in diversified investments (asset management firms) to put forward their joint opinion in urging investee companies to rethink their business and/or financial strategies. A group of foreign asset management firms engaging in the origination of Japanese stock funds have launched a joint initiative to develop a guideline for dialogue with investee companies, and plans are now underway to organize an investment forum for that purpose. I am looking forward to the development of their activities.
Meanwhile, as a way to encourage external shareholders to make long-term commitments, designing new types of investment vehicles such as classified shares is an important issue for consideration. In this regard, it is worthwhile considering the idea proposed by Colin Mayer, professor at the University of Oxford. In his recent book, Firm Commitment, he calls for introducing a system that enables shareholders to register the period for which they intend to hold shares and vesting more voting rights in shares transferrable than in common shares only after the committed period of time. Such a scheme would provide those shareholders interested in long-term profits for companies with greater incentives to monitor their investee companies, while issuing companies would be able to find shareholders committed to the long-term management of company business.
Restrictions on cross ownership
Lastly, in terms of stock ownership structures, it is necessary to reexamine the cross-holding of controlling shares between relatively small companies. The aim of the Code is to increase corporate value by reinforcing the stewardship responsibility of institutional investors. However, in the case of relatively small companies, institutional ownership is usually low and the proportion of shares held in cross ownership is large. Furthermore, all of the relevant empirical studies including ours found a significant negative correlation between the percentage of shares held in cross ownership (sum total of those held by banks and life insurance companies) in a company and the performance of the company (Note 3). This relationship has the following two aspects: 1) managers of companies with cross-ownership structures are protected from external pressure and thus make less effort (entrenchment effects), and 2) shareholders hesitate to sell off their shares in companies with poor performance in consideration of other business relationships with those companies. As such, cross ownership is a rational choice for both sides, and it would take external measures to disentangle this relationship.
However, it should be noted that empirical research also showed that block shareholding has a positive impact on corporate performance. Now, how to regulate cross ownership is one of the focal points in the ongoing debate for the establishment of Japan's corporate governance code. In designing the optimal regulation, the major challenge will be how to make a clear distinction between cross ownership for the purpose of securing excessive protection of a controlling interest and that based on actual economic relationships.
Introduction of independent directors
Another pillar of Japan's corporate governance reform in recent years is the reform of boards of directors that promote the appointment of independent outside directors. The latest amendments to the Companies Act would introduce the so-called "comply-or-explain" principle, requiring those companies that do not have any independent outside director to explain the "reason why it is not reasonable" to appoint one. It is expected that by promoting the introduction of such a highly independent organ, the amended law would solve corporate governance problems in those Japanese companies that continue to prioritize insiders' interest.
Structurally, the conventional boards of directors of Japanese companies can be defined as a "management board" with functions centered on making business management decisions. This characteristic has largely remained unchanged to date despite the rapid spread of the executive officer system since the late 1990s with an aim to separate the supervisory and operational functions. Given that, it would be unrealistic to expect that the appointment of few independent outside directors would bring fundamental changes. What is needed is to transform the conventional board of directors, i.e., management board, into a monitoring board that is specialized in the supervision of the management. The implementation of the amendments to the Companies Act would prompt many Japanese companies to appoint outside directors. Whether such moves will turn out to be compliance merely in form or bring substantive changes in the context discussed above is the point to watch.
However, it should be noted that not all Japanese companies need to shift to a monitoring board. In general, providing advice to top managers and executive officers and monitoring their activities are the functions expected of outside directors. Such independent, third-party monitoring is counted on to protect not only the interests of minority shareholders but also that of other stakeholders such as employees. This role is important particularly in those Japanese companies whose competitive strength lies in employees' commitment to the companies.
As summarized in Figure 3, the rationality of bringing in independent outside directors generally depends on the complexity of the business in need of advice (measured on the horizontal axis) and the seriousness of the agency problem of the company being monitored (measured on the vertical axis). The utility of third-party advice tends to be high in companies whose business is highly complex, as is the case for companies with a diversified business portfolio or those with numerous business units within the group. Meanwhile, the need for monitoring is relatively low in companies focusing on internal growth (e.g., emerging companies), and a conventional management board may be sufficient to fulfill their needs. However, in the case of those companies holding large cash reserves or having introduced anti-takeover measures with their business in its mature stage (e.g., established companies), external monitoring is highly necessary. The rationality of shifting to a monitoring board is particularly high where there is a serious conflict of interest between external investors and other stakeholders such as employees, i.e., in the case of companies with the following characteristics: 1) human capital is crucially important as a source of competitive advantage, 2) dependence on external finance is high, and 3) growth through M&A is a rational choice.
Focal point in the future reform of boards of directors
Following the 2002 amendments to the Companies Act, leading large-cap companies included in the MSCI Japan index have made steady progress in introducing independent outside directors, and almost all of them have at least one such director today. As of the end of June 2013, among the top 200 companies in market capitalization, those without any independent outside director were limited to only 24 companies, including Canon Inc., Nippon Steel & Sumitomo Metal Corporation, and Toray Industries, Inc. By the end of June 2014, 17 of them have appointed at least one independent outside director, bringing the number of those without any such director to seven.
In this sense, so far as those leading companies are concerned, the requirement of having at least one independent outside director has been fulfilled, and they do not necessarily have compelling reasons to reorganize into a "company with an audit committee." As one symbolic change, we can cite Toyota Motor Corporation's appointment of three outside directors in 2013. Up until then, even after the 2002 amendments to the Companies Act, which introduced a "company with committees" as a new, optional form of corporate structure, Toyota had kept to its policy of having no outside directors on its board, insisting that first-hand knowledge of business, especially knowledge on the shop-floor, is indispensable to its board members who are responsible for making decisions on important matters and the supervisory function can be properly fulfilled by the board of auditors, the majority of whom are outside auditors. On the same grounds, the company had also sought to have its directors serve as executive officers concurrently. However, with its overseas operations further expanded and having gone through the experience with vehicle recalls in the United States, Toyota appointed three outside directors—including one foreign national (former group vice president of General Motor Corporation) and a senior official of a financial institution (Nippon Life Insurance Company)—while maintaining the framework as a company with an audit committee. In terms of classification illustrated in Figure 3, this can be defined as a company with a management board having appointed outside directors by focusing on the advisory function for the time being. To what extent the presence of the three outside directors will enhance the supervisory function is the point to watch.
As implied by the above examples, the first challenge ahead for Japanese leading companies is to make a strategic choice as to whether they should strengthen the new characteristics of a monitoring board or maintain the conventional management board as a move in parallel with the appointment of outside directors.
The second challenge is to what extent they can achieve the diversity of board members by appointing foreign nationals and women in accordance with the characteristics of their business, external environments, and business positioning, in the case of appointing multiple outside directors. My personal view is that the presence of a foreign national on the board is an imperative for companies with overseas sales accounting for more than 50%.
Medium-sized companies and emerging companies (entrepreneurial companies)
In comparison, many of those companies facing little pressure from overseas institutional investors have no outside directors on board. As shown in Figure 3, theoretically, not all companies are in need of outside directors. In practical terms, the widely held opinion among law scholars and experts is that emerging companies would be allowed not to appoint any outside director, provided that they can explain the reasons for non-compliance, such as those relating to the characteristics of their business or the degree of potential conflict of interest. However, since supervision is an essential function for any organization, they would have to show that their reasons are well grounded, for instance, by proving the indispensability of fast-hand knowledge on business in deciding critical matters.
In relatively mature companies that are listed in the first or second section of the TSE, independent directors have a potentially significant role to play in terms of supervising their financial policies and management decisions concerning business restructuring or takeovers. Even in the case of emerging companies led and managed by their founding entrepreneurs, it is quite meaningful to appoint an outside director as a way to show commitment to preventing the abuse of power or reckless management by founder-managers, and it is also highly likely that advice from outside directors will help improve their corporate value. Regarding the roles that outside directors have played to date in Japanese companies, a collection of best practices introduced in a recent interim report (Note 4) of the Ministry of Economy, Trade and Industry's Corporate Governance System Study Group, which was released along with the Guidelines on Outside Directors and Kansayaku (audit and supervisory board members), would serve as a useful reference.
Also, making active use of audit and other committees as a transitional measure could be another effective approach for companies of this cohort.
Toward the reform of boards of directors
Past laws and regulations—whether amendments to the Companies Act or the TSE's securities listing rules—had been envisaged and established based on the mandatory principle which enforces them to all companies concerned. In reality, however, there is no one-size-fits-all mechanism of corporate governance that would lead to accelerated growth of companies. Given that, the comply-or-explain principle, which requires non-compliant companies to explain the reasons, is more desirable than the compulsory approach in the past. Ensuring the freedom of choice is crucially important particularly now that corporate governance arrangements among Japanese companies are so diversified.
In a move following the amendments to the Companies Act, discussions are now underway for the development of a corporate governance code. In addition to the aforementioned question of how to regulate cross ownership, to what extent to regulate the composition of boards of directors—i.e., the number of directors and the definition of "independence"—will be a focal point. My personal view on this issue is that the prospective corporate governance code should be confined to presenting principles. For instance, in setting provisions for the composition of boards of directors, we should be careful and refrain from regulating the number of outside directors and the criteria for independence too meticulously based on the assumption that a shift to a monitoring board is desirable for all Japanese companies. Imposing unreasonably stringent requirements could prompt listed companies to go private to avoid such regulations. It is hoped that the diverse realities of Japanese companies will be fully taken into account in the debate for the establishment of a corporate governance code.
The original text in Japanese was posted on September 29, 2014.
November 25, 2014
