Reforming Japanese Corporate Management: Independent audit committees should be established

Faculty Fellow

Debate over the design of the Japanese corporate system of the future is gaining momentum once again in tandem with the development of growth strategies by the government. In the wake of the banking crisis that ran from the 1990s to the early 2000s, the corporate system has been changing swiftly in Japan. Cross shareholdings with banks are being unwound rapidly, such that leading Japanese companies are approaching a shareholding structure dominated by outside shareholders, centering on institutional investors, as in other developed nations.

For the top 200 companies by market capitalization (as of the end of fiscal 2011), the shareholding ratio of banks and business corporations was 35.6% on average, while that of domestic and foreign institutional investors stood at 38.9%. Adding the shareholding by individual investors, those who hold shares for the purpose of financial gain and investment accounted for more than 50% of the total. Also, in a questionnaire recently conducted by RIETI, in which I played a central role, the respondents who answered "giving higher priority to shareholders" exceeded those who answered "giving higher priority to employees" to the question, "To which stakeholder do you give higher priority at the moment?"

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At the same time, however, many Japanese companies are still maintaining the lifetime employment system for their core employees, although the weighting of regular employees is being reduced. In the same questionnaire, there are relatively few companies planning to change their wage system significantly or increasing the number of fixed-term workers considerably. Rather, companies that had a policy of partially introducing a merit system, while assuming the lifetime employment system, made up the majority. In addition, companies that answered "employment" to the question, "When business results worsen, to which do you give preference, dividends or employment?" accounted for 90%.

As just described, a hybrid structure of rising outside shareholders in the shareholding structure and the maintenance of the lifetime employment system has begun to characterize the leading Japanese companies today. American and British companies have a shareholding structure dominated by outside shareholders such as individual and institutional investors which is combined with a fluid labor market and skills formation by employees outside of the company. On the other hand, leading companies in continental Europe and Asia have a shareholding structure dominated by insiders such as founding families and affiliated companies which is incorporated with a moderately fluid labor market and skills formation outside of the company. In that sense, the hybrid structure of existing Japanese companies is unique in an international comparison and therefore has problems that differ from those in other regions.

One of the serious defects of this hybrid structure of Japanese companies is that the commitment of outside shareholders represented by foreign investors to the companies in which they invest is still limited, nonetheless their shareholding has increased notably. The case of Olympus Corporation illustrated this problem vividly. Although serious issues about the company came to light with the sacking of Michael Woodford, which fueled calls for change from some foreign investors, the involvement of outside shareholders in the rebuilding of the company was ultimately shown to be difficult.

While Olympus' shares continue to be held by banks and business corporations (39.4% of outstanding shares as of the end of fiscal 2010), the shareholding of outside shareholders (foreign investors and domestic institutional investors) is high (42.0% of outstanding shares as of the end of fiscal 2010). However, they remain unable to exercise effective control because their respective shareholdings are fragmentary. What is noteworthy is not that traditional stakeholders such as banks and corporations took the initiative in the rebuilding (the commitment of insiders was too strong), but rather that domestic and foreign institutional investors were remarkably passive in the rebuilding (the commitment of outside shareholders was too weak), with the exception of certain foreign shareholders.

This suggests that there is a vacuum in the governance system of even the leading Japanese companies. It is true that outside shareholders have been strengthening their influence over financial policies such as dividends payout, but they have yet to exercise their control effectively. Outside shareholders naturally have an interest in the performance of the company, but the fact that the lifetime employment system is maintained and has become the infrastructure for employee skills formation means that the interests of employees are still crucial for the performance of the company. Therefore, for Japanese companies to move forward, it is necessary to achieve an appropriate balance between the interests of outside shareholders and their commitment to management.

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I have been discussing with Professor Colin Mayer of the University of Oxford about measures to rebalance both interests. First, what is worth considering is the design of share classes that will enable shareholders to make a long-term commitment. A useful method of providing shareholders with an incentive to hold shares for a long period would be to allot them extra dividends based on how long they have held their shares. In the case of Japan, however, given that the focus would be on how to raise the level of commitment of shareholders to the company, an effective method would be to grant greater voting rights, especially the rights to elect and dismiss directors to shares that are held for a long period into the future, as compared to the rights granted to common shares.

The issuance of share classes itself is not unheard of internationally. Google Inc. in the United States used it when it was listed. In fact, some European companies that have achieved worldwide success also practice this dual class share issuance. For example, Groupe Danone and Carrefour S.A. in France, Unilever PLC, an Anglo-Dutch multinational company, and the Carlsberg Group in Denmark have been using this type of share issuance for years. In many of these cases, an industrial foundation becomes a long-term shareholder.

In Japan, this scheme of multiple voting rights should be applied to encourage the commitment of outside shareholders to corporate management. Candidates for long-term shareholders of Japanese companies are domestic and foreign institutional investors such as pension funds and life insurers. The introduction of this system of giving greater voting rights to shareholders who are committed to holding shares for the long term will encourage foreign institutional investors to play an important role in improving their monitoring and governance of companies in their portfolio over a longer time horizon. The introduction of share classes will also invigorate the governance activities of domestic institutional investors (insurance companies and others) who have been inactive in exercising their voting rights, while holding shares for the long term.

The second consideration is how to design a highly independent body that supervises the executives responsible for corporate management (in fact, the boards of directors which are composed of insiders are still engaged in management at many existing Japanese companies). Another feature of leading European companies that have an industrial foundation as a major shareholder, such as the companies mentioned above as well as Robert Bosch GmbH of Germany and IKEA of Sweden, is the monitoring of management by an independent audit committee. Its major mission is to assure that management complies with the principles of the foundation and reflects the interests on management of not only shareholders but also different stakeholders such as employees.

To make this a reality in Japan, one practical approach is to actively use an audit and audit committee that companies will be able to choose, after the amendment of the Companies Act. It is necessary to ensure that the committee is of a sufficient scale and clarifies the scope of the audit, increases the independence of the members, and has representatives of long-term investors participate.

This organizational reform is particularly important for Japanese companies for two reasons. First, as the Olympus scandal shows, more effective monitoring of management is needed, and an audit committee comprising officers independent from the current management is the best way to do this.

Second, for leading Japanese companies whose competitiveness is based on internally developed core technologies, it is reasonable to maintain the benefits of the lifetime employment system as they transition to placing higher priority on outside shareholders. It is therefore essential to achieve a balance among the interests of different stakeholders with this independent audit committee. In this regard, the role played by this independent audit committee is similar to the role taken by the board of corporate auditors, separate from the board of directors, as observed in German companies.

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The creation of long-term shareholders and the introduction of an independent audit committee can realize management focusing on the long term, which is a characteristic of Japanese companies, and satisfy both the maintenance of the lifetime employment system and efficient governance. That could solve problems such as a low return on equity (ROE) and thus become the key to the growth of Japanese companies. Japanese companies should seek the design of share classes that will make long-term shareholding reasonable and a body that could ensure effective monitoring of management. If these schemes are implemented, then long-term investments of domestic and foreign institutional investors are likely to be encouraged, and these investors should be able to play a more dynamic role in monitoring management.

>> Original text in Japanese

* Translated by RIETI.

May 14, 2013 Nihon Keizai Shimbun

June 17, 2013