Toward Shareholder Stewardship of Corporate Governance

Faculty Fellow, RIETI

Themes related to corporate governance are becoming the focus in discussions on Japan's growth strategies. Examples include the Japan's Stewardship Code, which defines a code of conduct for institutional investors as shareholders, and reform of the Government Pension Investment Fund (GPIF).

What these discussions have in common is the intent to enhance the imposition of discipline on corporations by shareholders. In the background lies the awareness that one of the factors behind Japan's slow growth is slow productivity growth stemming from inadequate corporate governance. Some argue for taking measures to boost share prices or return on equity (ROE) as targets, but, ultimately, improving productivity is essential for boosting up the economic growth rate.

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Japanese-style corporate governance seeks to optimize benefits for stakeholders, including employees, customers, and the local community, in addition to shareholders. There is also the view that it does not necessarily follow that corporate discipline is weak simply because profits for shareholders have not been maximized. (See, for example, the 2012 volume Corporate Finance and Governance in Stakeholder Society: Beyond Shareholder Capitalism by Shinichi Hirota of Waseda University).

However, no matter how value added is distributed between capital and labor, growth in total factor productivity (TFP) in the Japanese economy undoubtedly has been sluggish for the past two decades. This fact was pointed out in a 2002 paper by Hitotsubashi University Professor Fumio Hayashi and Arizona State University Professor Edward C. Prescott, and has been confirmed by research utilizing the Japan Industrial Productivity (JIP) Database compiled by RIETI in collaboration with other institutions (for example, Japan's Economy and the Two Lost Decades, published in 2012 by Hitotsubashi University Professor Kyoji Fukao). The causes of the sluggishness in TFP growth are unclear, but guiding corporate governance onto an appropriate course could potentially boost productivity.

In Japan, reform has proceeded on the side of investees, but has not yet progressed on the investor side. We have seen major reforms in the former, including the introduction of the stock options system and the lifting of the prohibition on holding companies in 1997 and the introduction of the "Companies with Committees" system in 2003, but there have been no conspicuous reforms on the investor side.

The problems on the investor side can be broadly divided into two issues. The first is that Japanese institutional investors overall tend to be passive or indifferent about engaging with their investees. Initiatives toward the introduction of a Japanese-style Stewardship Code are intended to change this attitude of Japanese investors.

Institutional investors comprise the providers of funds (asset owners)—e.g., life insurance companies and pension funds—and the companies that operate these investments (asset managers), and invest in shares on their behalf. Each of these two groups has its respective problems. It can be assumed that one aim of the reform of the GPIF is to change the conventional wisdom among asset owners.

A change in the orientation of the GPIF's operations to emphasize engagement would have a significant effect on Japanese asset owners as a whole. Meanwhile, the passive stance of asset managers also stems from the non-competitive practices that are prevalent in the industry (e.g., there is no widespread contingency fee system). Among issues for the future are the allocation of funds for management and the establishment of conditions by asset owners that will encourage the entry of independent asset management companies into the market, and the introduction of mechanisms to enable these new entrants into the market to outsource their clerical duties.

The second of the major issues mentioned above is cooperation between shareholders. Cooperation between multiple shareholders participating in corporate management can be called "cooperative behavior." Under the existing system, which emphasizes the equality of shareholders, shareholders from a diverse range of backgrounds individually make demands to companies. The more seriously that the shareholders and the company view their involvement, the more monitoring costs are duplicated on the shareholder side, and the more time and labor are involved on the company side in responding to multiple shareholders.

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Nominating a representative (or a delegate), determined on the basis of shareholdings, to monitor corporate management and apply discipline from the perspective of benefitting shareholders as a whole is one method of reducing these costs. This is known as "delegated monitoring," and, in the field of economics, this concept has been employed numerous times in analyzing the relationship between multiple creditors and a single debtor (a company).

In his 1984 paper, University of Chicago Professor Douglas Diamond analyzed the loaning of funds to a single corporation by multiple creditors. Professor Diamond indicated that banks are entities that bring together the funds of creditors (depositors) and act as delegates in the monitoring of corporate management. The development of Japan's main bank system represents a type of delegated monitoring, in which multiple banks provide funds to a single corporation, and the main banks act as representatives of the other banks in monitoring the management of that corporation.

For listed companies with multiple shareholders, reducing communication costs is an essential condition for the realization of governance by shareholders. In this, consideration of a main bank-type mechanism has merit. What should be created is a system in which a "lead shareholder," representing the interests of the shareholders as a whole, participates in corporate management.

There is a preceding case of the lead shareholder overseas. According to a 2014 paper by Ryoko Ueda, senior research fellow with Japan Investor Relations and Investor Support, Inc., a type of institutional investor known as a proxy pool fund has been active in the United Kingdom. This type of fund is granted rights by other shareholders to participate in the management of companies that are subjects of investment. This approach is considered to dramatically reduce communication costs between shareholders and companies and to contribute to increased productivity.

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However, there are significant risks involved in consigning or entrusting shareholders' rights. For example, entrusting voting rights was used at the end of the 19th century in the United States as a means for financial capital to dominate companies and establish monopolies. ("Trust" as used in the U.S. antitrust laws refers to the "entrustment" of voting rights). There is also the possibility that monopolies would damage market efficiency and contradict the common interest of the shared shareholders in maximizing long-term corporate value.

From this perspective, it would be essential to regulate mechanisms that might enable a certain number of shareholders to accumulate excessive rights from other shareholders or to do so in an unfair manner. Advances in financial engineering have enabled methods for funds to obtain shareholder rights far in excess of their contribution, but these methods are also considered to be unfair.

A mechanism of the following type could be considered as a means of introducing a lead shareholder system that is fair and does not impede market competition.

First, regulations would be eased in order to promote cooperative behavior among shareholders, and protections for small-scale shareholders would be enhanced to balance this. A cash-out mechanism enabling the lead shareholder to purchase shares from small-scale shareholders for a fair price also would be introduced to ensure that small-scale shareholders do not possess excessive bargaining power.

Following this, a loose grouping of major shareholders would be formed. This grouping would pay the lead shareholder a service fee for monitoring corporate management and exerting influence as necessary. In order to create a system of this type, it would be necessary to relax the principle of equality between shareholders, and this presumably would necessitate revision of the Company Law and other laws and regulations.

Such mechanisms are not found among the main institutional investors in the United States and Europe. Instead, institutional investors who are majority shareholders are experienced in participation in corporate management, and there is little gap between shareholder opinions. Because of this, despite the fact that there is no lead shareholder, individual shareholders cooperate in practice and impose discipline on corporate management based on a unified orientation.

In other words, if corporate investors become highly experienced as actors in governance, the lead shareholder system would be unnecessary. It represents a beneficial mechanism for a period of transition. From this perspective, the system can be significant for contemporary Japan, where the investment behavior of institutional investors currently is undergoing a period of transition.

>> Original text in Japanese

* Translated by RIETI.

October 8, 2014 Nihon Keizai Shimbun

November 10, 2014

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