Japanese Corporate Governance: Moving in the Right Direction or Dead in the Water?

Regarding corporate governance in Japan, I would like to relate my own background (including a few war stories) first. That way you'll know my perspective and why I think there's a problem with Japanese governance. Then I would like to describe who I perceive as the main players in the Japanese corporate governance drama.

I finished my law degree in 1969 with the idea that I would spend a lot of my time representing Japanese clients. At that time, Japan was not big in terms of deals. But by the 1980s, there were more and more Japanese companies coming into the US-plenty of deals to help them do. There are pros and cons to representing Japanese firms. The good side is that Japanese never say, "It is only a job." In other words, the job is life itself. So it is possible to get lots of positive feedback when you help them. The bad side is the other side of the coin: because the job is life itself, a lot is driven by emotion, which creates its own momentum. Japanese clients often would not listen to my advice.

Not listening to advice got companies into trouble big time during the bubble. Price was always an issue. They called it the tsunami bid-the huge bid for a company that swept away everything in its path. I would hear directors of Japanese companies say things like, "Just raise the bid by 50%. We are going to buy!" The investment bankers would try to stop them, to no avail.

The conventional wisdom among American sellers was: if Japanese were buying a company, it was the Japanese side that would always cave. A deal would take place merely because the company's president's plane was ready to go; or people would be intimidated and shut down discussion because the president would get angry if the deal wasn't made. The level of discussion was unbelievably low.

Japan has continued to do business like this even after the bubble. We would see bubble-type deals being made after the bubble, in the mid 1990s for example. And Japanese bank officers would rather drive a paper company into a discrete bankruptcy abroad and write its debts off their balance sheet than risk the publicity that would result from taking those of its affiliates that had the assets to court. These are severe failures of corporate governance.

I had lost hope in Japan as a place for international lawyers to find much useful to do. But then in 1997 and 1998-all of a sudden it seemed-we began to see many new deals like Ripplewood-Long Term Credit Bank (LTCB) and Salomon-Nikko. So I came back to Tokyo, after four years in China. The following is a description of the new players I encountered in the Japanese corporate governance drama.

The first actor is the Japanese judge. I noticed that at the end of many projects, my clients would ask me, "Can the directors be sued?" This was the first time to hear this question in Japan. Shareholder derivative suits were now possible because the filing fee had been lowered in 1993 to only 8200 yen. Shareholders could now sue and win, and the directors would get nailed. So the president of a company might get angry if a deal didn't take place, but that was nothing compared to the threat of a lawsuit for a dumb deal. The Japanese judge had been brought into the drama, which forced people to consider shareholder value, whether they wanted to or not. There have been some recent revisions to the rules on these lawsuits in the company law. One problem with the revisions is that the company can now side with the company director during these suits. This is entirely inconsistent with the concept of these suits-they are to determine whether the director has harmed the company. The revisions also provide new settlement procedures, but there could be more disclosure in connection with settlement so as to prevent collusion between management and plaintiff shareholders. But in any event, overall the judge is still the most important actor in Japanese corporate governance.

The second actor is the statutory auditor, an actor that was strengthened under those same recent revisions. People say that the statutory auditor has little to do and it is no wonder that so many of these fellows are so old-the job is merely an excuse for them to continue coming down to the office. I am skeptical about the statutory auditor ever becoming a force to be reckoned with. Companies often say they do not need outside directors because they already have a statutory auditors; but it is really just an excuse to avoid having outside directors.

Which brings us to the third actor: the outside director. Under further revisions just enacted Japanese companies can now elect to adopt the American model- a board of directors that includes an audit committee, a compensation committee, and an audit committee with a majority on each being outside directors. There are some incentives in the revisions to adopt this model. But so far not many companies are planning to do it-the number is less than one percent of all companies in Japan. No Japanese president wants to give up the right to name his successor. By the way, you should not attach too much importance to Enron: boards fire presidents in the US in hundreds of cases for far less bad things. A problem in Japan is that the definition of outside director is too easy to satisfy; outside directors are not necessarily independent ones in Japan.

The fourth actor is the outside accountant. Companies need outside accounting certification. Japan now has world class accounting principles, as a result of the accounting big bang. But auditing standards are a different story. When outside auditors screw up in the US, they are punished. That is accountability. In Japan, when a company is going in the tank, you often could never tell by its accounting statements. When companies go under in Japan, what happens to the accountants? You cannot sue accountants easily in Japan. Compare this to what happened to Arthur Anderson. It should be easier to sue. Class action suits are not yet possible here. Japan could use a Securities and Exchange Commission (SEC) analogue. Finally, the Japanese government, for example the Financial Services Agency (FSA), should get out of the way, and let accountants do their job.

The fifth actor is actually an individual: it is Yoshiaki Murakami, an alumnus of the Ministry of International Trade and Industry (MITI). It is too bad that there is only one person like him. There is no market for corporate control in Japan. In the US, managers can be kicked out when they perform poorly, their company's stock goes down, and they are subjected to a hostile takeover. In Japan, you have cross share holding. Yes, cross share holding is coming down, but it's still there to shelter weak management when needed. There is a saying: a man can drown in a lake with an average depth of just one meter. Japan could prohibit cross share holding and prohibit banks from holding stock.

The sixth actor is the investment manager or institutional shareholder. There is a lot of potential here. There could be a seventh actor too: that would be the individual shareholder. Perhaps it should be easier for shareholders to make proposals. In the US, you only need $2,000 worth of stock to make a proposal.

In sum, the strongest force is the judge. This is a bit unhealthy. The outside accounting function has potential. There needs to be a market for corporate control.

Q: Mr. Murakami has not always done his homework. He has underbid. Sometimes potential changes in accounting principles gets leaked and aired out in the press. A word about the statutory auditor: the president rewards loyalty.

True, but Mr. Murakami is inventing this as he goes along. Orix has to worry about its shareholders too-otherwise they could have helped him with more money.

Q: Lots of things can be done in Japan. Meanwhile, other Asian countries are moving along very rapidly compared to Japan. Japan many not win the race.

Q: What incentives are needed to make outside directors more active in Japan?

listing requirement (like on the New York Stock Exchange) of independent (not just outside) directors would help. The Tokyo Stock Exchange should be more active in these matters. The real problem is that Japanese people just don't like conflict. So there is a tendency to look for people who are compatible. Very few companies have a majority of outside directors.

Q: What about companies in Japan that do not favor outside directors, yet are nevertheless performing quite well?

Yes, these include companies like Toyota and Canon. The involvement of outside directors is only one factor of performance.

Q: When will we see real changes in Japan?

Things will change, but slowly. Only one percent of companies are ready to adopt outside directors. But that may be up in a year or two. The system worked well for decades, and there has really been only one bad decade. You have to look at these problems with a long time perspective. Remember Chou En-lai's response to Henry Kissinger's question about whether he thought the French Revolution had been a success or not: "It's probably too early to tell."