Topics in Corporate Governance Reform: Encouraging management that can take risks

Faculty Fellow, RIETI

The debate over corporate governance as part of a growth strategy is growing more intense. Japan has passed a revised Companies Act that encourages businesses to appoint independent outside directors. Japan has also started using its own version of the British Stewardship Code, which calls on institutional investors to seek out engagement actively with the companies in which they invest. This column reviews the changes in Japanese corporate governance since the financial crisis of 1997 and then considers directions for future reform.

First, let's look at the trend in the number of Japanese companies listed on stock exchanges. Looked at internationally, large enterprises in Japan clearly have a strong tendency toward being listed. In 1998, listed companies made up 70% of the top 500 companies in terms of sales. In the United Kingdom, the figure was just 28%; in France and Germany, roughly 14%; and in Italy, less than 10% (out of the top 1,000 companies in 1996). Meanwhile, the number of listed companies in the United States dropped by 38% between 1997 and 2011. During the same period, the number of listed companies on major British markets fell by 48%. On the other hand, in Japan, the number rose from about 2,300 to 3,600 in the same period. When considering the earnings capability of Japanese enterprises, it is very reasonable to focus on the governance of listed companies.

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Since the financial crisis of 1997, the ownership structure of listed companies in Japan has changed dramatically. The percentage of stock that institutional investors own in companies on the Tokyo Stock Exchange rose from 23% to 48% between 1996 and 2013. This is lower than the 80% mark in the United Kingdom and 60% in the United States during the 2000s, but it is equivalent to the level of the United States in the 1990s. Of this, more than 30% was owned by foreign institutional investors in 2013. However, these investors have been facing informational problems, so that investee companies are limited to enterprises with large market capitalization and high liquidity.

Meanwhile, ownership by industrial corporations, banks, and insurance companies stood at 56% in 1996, dropped sharply to 34% by 2006, and since then has declined slightly, standing at 31% in 2013. These stable investors actually play the same role as do private equity funds in the United Kingdom and the United States, where such funds are on the rise.

Private equity funds in the United Kingdom use takeover bids to make a company private, which frees corporate management from the short-term pressure of shareholders and helps the business to achieve its mission. Private equity funds also are actively involved in managing and monitoring investee businesses. Likewise, Japan's industrial corporations and banks also help to stabilize management by committing to hold stock for the long term. These shareholders intervene to rescue businesses when they face their financial distress.

In both cases, however, corporations are dependent primarily on borrowing to raise external funds. Lacking the buffer of equity, they are vulnerable to outside shocks. This fault revealed itself in the slow recovery of Japanese corporations after the bubble economy collapsed and in British corporations after the collapse of Lehman Brothers.

This weakness is being overcome gradually in Japan. In the past two decades, Japanese enterprises have enjoyed the benefits of being listed while maintaining a stabilized shareholding system. They have also benefited from the increase in investment from foreign and domestic institutional investors. This evolution differs either from that in the United Kingdom and the United States, where institutional investors are a majority and the number of listed companies has fallen, or from that in continental Europe, where the number of listed companies is small, and there is a high level of concentration of stock in the hands of corporate founders and other corporations.

Therefore, the problems of Japanese corporate governance are also very different from those of the United Kingdom, the United States, and continental Europe. The main problem in continental Europe is a conflict of interest between founders and their companies. The problems in the United Kingdom and the United States since the collapse of Lehman Brothers are that investors with a short-term view encouraged top managers to take mergers and acquisitions (M&A) excessively and other strategies with high risk.

Japan has the opposite problem instead—outside investors do not have much control, and conservative, risk-averse management is thriving. The reforms currently being debated have to do with the need to re-balance the interests of shareholders and other stakeholders. Specifically, Japanese businesses need to reflect the interests of outside investors better while maintaining the existing advantages of the Japanese business world: long-term commitment of shareholders and employee involvement in management.

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The Japanese Stewardship Code, announced in February 2014, is an opportunity to achieve this re-balance by strengthening the monitoring of investee companies by institutional investors. The code asks that asset managers (of asset management firms, insurance companies, etc.) and stock owners (pension funds, etc.) become more transparent about their investment policies and engage in more dialogue. It requires that investors come to a common understanding of their priorities with investee businesses. The code also strengthens accountability to beneficiaries.

By asking institutional investors to gather enough information and clarify their policies on exercising their voting rights, the code fleshes out how institutional investors choose to vote. Until now, the standards by which they evaluate decisions have been rather perfunctory. The code also asks institutional investors to identify conflicts of interest and state how they plan to respond to them. This is an opportunity to bring more transparency and reliability to investment managers. In the past, fund managers were often under skepticism in that they may not have always maximized the interest of beneficiaries, but rather considered their other concerns such as the relations with groups firms as well as their other businesses when selecting stock to purchase.

However, the code seems to have some serious difficulties, specifically in its ability to strengthen monitoring by institutional investors through engagement. For a shareholder to contribute to the sustained growth of a company, it is indispensable for investors to make a commitment to hold that stock for the long term. On the other hand, the business model of asset management firms is to reduce the risk by diversifying their investment portfolio, thus they make no commitment to long-term ownership.

If an institution is mainly involved in the business of organizing active funds with short holding periods (about one year), it would be difficult to expect it to engage in dialogue for the medium- to long-term growth of the company. There are also limits on how much of the cost of dialogue will be paid by institutions that run index funds, which mechanically buy and sell the stocks according to market indexes.

For strengthening monitoring, investors such as insurance companies that are committed to long-term investment are also expected to participate in the engagement process, and to show their policy clearly. Most insurance firms declared that they have endorsed the Stewardship Code. It is a welcome movement because insurance companies previously were known as "silent shareholders." Now the spotlight is on how banks will respond.

Furthermore, new mechanisms need to be studied for encouraging long-term ownership. An example might be dual class shares. Professor Colin Mayer of Oxford University (who is the author of Firm Commitment) has proposed one idea that merits consideration: investors would register how long they intend to own shares and be given greater voting rights over shares to which they commit for the long term than would be the case with ordinary shares. This would better motivate long-term shareholders to monitor investee companies and make it easier for companies to attract stable shareholders.

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Another element for re-balancing the interests of investors and others stakeholders such as employees is to introduce independent directors for monitoring the management. The revised Companies Act requires companies, if they choose not to appoint independent outside directors, to explain their reasoning. This is a new way of encouraging independent monitoring, based on "the comply or explain principle."

At most Japanese companies, the board of directors could be called a management board rather than a monitoring board, as it is heavily involved in making management decisions. Even since the widespread adoption of the executive officer system, which claims to separate monitoring and executive functions, the characteristics of the management board still has not changed much. As long as companies maintain this structure, no fundamental change can be expected even if they appoint one or two independent directors. What is needed is to reform the traditional board of directors into a mechanism that can be called a monitoring board, because it would specialize in the supervision of management. A key question going forward is whether the introduction of outside directors brings real change or if it is just superficial window dressing.

It is not necessary for every Japanese company to switch to a monitoring board system. The functions expected of outside directors are advising and monitoring the executive management team. Independent third-party monitoring is also expected to protect the interests of not only minority shareholders but also employees and others. This role is especially important for Japanese businesses, in which employee commitment to the company is considered a source of competitiveness.

In general, the rationality of bringing in independent directors depends on the complexity of the business that is in need of advice (the horizontal axis in the figure) and the seriousness of the agency problem, i.e., conflict of interest between investors and managers (the vertical axis). The more diversified the company's business portfolio is, the more useful it is to get advice from outside. Newer emerging companies, on the other hand, which are mainly pursuing internal growth, have less need for monitoring, and may be fine with the current type of management board.

Figure: Company Characteristics and Role of the Board of Directors
Figure: Company Characteristics and Role of The Board of Directors

However, as companies' businesses mature, the agency problems are likely to be serious in the sense that they retain unnecessary cash or take defensive measures against a takeover. For these companies, monitoring is critically important. Additionally, even at leading companies, it would be very rational to shift to a monitoring board if there is the potential for serious conflicts of interest between employees and investors. For example, it is reasonable for companies whose competitive edge mainly depends on their human resources or companies which highly rely on outside funding. Furthermore, it is also rational for companies that may find it essential to reconfigure its business or be inclined to grow through M&A.

It is hoped that Japanese businesses will take the revised Companies Act as an opportunity to choose an appropriate type of board of directors that fits their business characteristics and stakeholder relationships.

>> Original text in Japanese

* Translated by RIETI.

August 6, 2014 Nihon Keizai Shimbun

September 4, 2014