Corporate Governance: The role of institutional investors will become crucial

Faculty Fellow, RIETI

The Tokyo Stock Exchange (TSE) began to apply Japan's Corporate Governance Code, which sets forth corporate governance norms for listed companies, in 2015 which is referred to as "Year One" of Japan's corporate governance reform. Under the code, listed companies that have only internally promoted directors on the board are urged to appoint at least two independent outside directors while those maintaining shareholding relationships for non-investment purposes are required to explain such relationships.

The Corporate Governance Code is based on the complain-or-explain principle. As such, while promoting reform by providing a set of principles that should be abided by to achieve desirable corporate governance, it provides a leeway for companies to opt out by explaining why they do not follow certain principles. In this regard, the code is commendable as a fairly flexible system. At the same time, however, this means that the enforcement of the code is limited and hence its effectiveness hinges on how investors respond to reform efforts by investee companies. Accordingly, ownership structures have a significant influence.

In what follows, I would like to review the characteristics of ownership structures in Japanese companies and examine what conditions are necessary to ensure the effective operation of the code.

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The expectations of the code when companies neither comply nor explain sufficiently are for shareholders to force them to correct their behavior either by exercising their voting rights (voice) or selling shares in those companies (exit). The institutional design of the code reflects changes in ownership structures in Japanese companies since the financial crisis in the 1990s.

Shareholders' meetings of Japanese companies were often criticized for being nothing more than a formality. However, since 2005, which saw a significant increase in the proportion of shares held by institutional investors in Japan and overseas, there has been a growing number of cases in which dissenting shareholders affect the choice of financial policies and governance systems. Furthermore, when the government made it mandatory for listed companies to disclose shareholders' voting results effective from 2010, the proportion of votes against the proposed slate of directors took on significance as a measure of the validity of corporate governance.

The influence of institutional investors by means of their exit has also increased over the years. In joint research with Kobe University Associate Professor Takaaki Hoda and Waseda University Research Assistant Ryo Ogawa, we conducted an empirical analysis of Japanese listed companies based on data for the period from 1990-2013. We found that institutional investors are inclined to select companies that have a smaller number of directors, a higher proportion of independent outside directors, and smaller shareholdings for non-investment purposes as a percentage of total assets. Also, changes in the portfolios of institutional investors have a real impact on share prices.

As such, the effectiveness of corporate governance reform is affected by the behavior of institutional investors and market valuation. However, it is not that currently listed companies have equally shifted to an ownership structure characterized by a significant presence of institutional investors. Today, ownership structures in Japanese listed companies are far more divergent than they used to be prior to the financial crisis (see Table).

When we compare listed companies by dividing them into five quintiles based on the size of market capitalization, the percentage of shares held by overseas institutional investors as of the end of March 1991 was as low as about 5% even in those companies with the largest market capitalization. However, as of the end of March 2014, the percentage of such ownership in those with the largest market capitalization rose to 30% whereas for those with the smallest market capitalization, it remained at 5%.

Table: Institutional Shareholdings in Listed Companies by Size of Market Capitalization
Percentage of shares held by overseas institutional investors Percentage of shares held by institutional investors Percentage of companies that have at least one block holder, i.e., an investor holding at least 3% of a company's equity
As of end of March 1991 As of end of March 2014 Institutional investors Insurance companies Leading creditor banks
Average 3.3% 15.4% 23.7% 40.8% 22.5% 25.9%
5th quintile 5.2% 30.1% 40.6% 49.1% 30.8% 15.2%
4th quintile 4.0% 19.5% 30.3% 56.6% 17.4% 20.8%
3rd quintile 3.0% 13.4% 21.8% 46.4% 24.1% 29.3%
2nd quintile 2.8% 9.0% 16.5% 36.1% 23.9% 33.9%
1st quintile 1.6% 5.0% 9.3% 16.0% 16.2% 30.2%
Note: Unless otherwise stated, all of the percentage figures are calculated based on data on a total of 1,638 non-financial companies listed on the First Section of the TSE as of the end of March 2014. The figures as of the end of March 1991 are based on data on 1,187 non-financial companies listed as thereof. The fifth quintile contains the largest companies in terms of market capitalization. The shareholding ratios for each quintile are average ratios for the quintile. Based on joint research with Ryo Ogawa.

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The enforcement of the Corporate Governance Code varies depending on the level of institutional ownership. For instance, in the case of the companies comprising the JPX Nikkei Index 400, the percentage of shares held by Japanese and overseas investors exceed 50%. So far as those leading companies are concerned, institutional investors will continue to ensure progress in corporate governance reform by means of voice and exit.

The code states that companies should, in principle, appoint at least two independent directors. However, the effectiveness of independent directors varies depending on the characteristics of each company such as the complexity of its business and the degree of conflict of interest between shareholders and corporate insiders, and having multiple independent directors could bring more drawbacks than benefits. Conversely, the presence of multiple independent directors does not automatically improve corporate governance.

In joint research with Keio University Associate Professor Takuji Saito and others, we estimated the relation between presidential turnover and company performance, and found that poor business performance increases the likelihood of presidential turnover only in companies with at least three independent directors. For companies with two or fewer independent directors, a decrease in the likelihood of presidential turnover was observed in association with poor business performance.

Shareholdings by non-financial companies tend to lead to lower capital efficiency in an investee company, and there is a high likelihood that such practices—pursued in the form of cross-shareholding—have an entrenchment effect that safeguards management's control over the investee company. At the same time, however, when a non-financial company holds a significant percentage of shares in an investee company, it provides the foundation for the investor company to supervise the management of the investee company. It has been confirmed in many empirical studies that the presence of such block shareholders has a positive impact on the profitability of the investee company.

This makes it all the more necessary for leading companies, i.e., those large cap companies referred to above, to design a corporate governance mechanism by properly incorporating their respective characteristics, and clearly explain why their governance mechanism is designed in such a way including the reasons for not complying with certain principles in the Corporate Governance Code. It is also crucial that institutions investors, for their part, work to enhance dialogue with investee companies rather than focusing solely on formality requirements.

Meanwhile, it is hard to expect significant changes in companies with low institutional ownership as a result of applying the Corporate Governance Code. Actually, those are the kind of companies that are meant to be the primary target of the code. However, if the enforcement of the code is dependent on the effectiveness of equity governance through voice and exit, its enforcement vis-à-vis companies with low institutional ownership is not ensured.

Here we see the dilemma of the Corporate Governance Code that guarantees the freedom of choice. Still, I believe that the application of the code will gradually change corporate governance structures of Japanese companies through the following channels.

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One is that the application of the code makes it more rational for company managers to work on corporate governance reform. As pointed out by University of Tokyo Professor Wataru Tanaka, the application of the code prompts companies to create a pool of potential candidates for independent directors, typically comprising retired chief executive officers (CEOs) and corporate directors. With the implementation of the code, relevant training programs for employees would be developed, and as they proceed with this endeavor, the cost of implementing the selected corporate governance system will decrease. Also, if some early mover companies successfully attract institutional investors by reducing their shareholdings for non-investment purposes and a vast number of other companies take the lesson from this example, it will become a starting point of dissolving cross-shareholding arrangements.

Another channel is via institutional investors' influence as shareholders, namely, in which direction they move in increasing involvement in the management of investee companies in which they have hitherto held a relatively small proportion of shares. As the liquidity of those companies' stocks tends to be low, the voice of block shareholders—which have sufficient incentive for monitoring and getting involved in the management of investee companies—is more important than the exit mechanism. There are three potential candidates for block shareholders.

The first candidate is investment funds characterized by a focused, long-term investment strategy to hold selected stocks. Among the companies listed on the First Section of the TSE, 41% have at least one institutional investor holding 3% or more of their shares (block holder), and the differences by the size of market capitalization are relatively small in the second to fourth quintiles. The substantial presence of block holders in the companies belonging to those quintiles could play an important monitoring role in the future.

Furthermore, in the case of companies with small market capitalization, it is relatively easy for outside investors to become block shareholders and domestic institutional investors are the primary candidates. It is worthwhile considering measures to have greater portions of public pension funds managed by fund managers pursuing a focused long-term investment strategy.

The second candidate is insurance companies, which are often referred to as "silent shareholders." As large as 22% of TSE First Section companies have at least one insurance company as a block holder, and the differences by the size of market capitalization are relatively small. It has been pointed out that Japanese life insurance companies might be giving consideration to potential impacts on other transactions (e.g., boosting insurance policy sales) in making investment decisions and exercising voting rights as shareholders. However, those insurance companies that have accepted the Japanese Stewardship Code, a set of principles for responsible investors, are now moving to expand the scope of matters subject to scrutiny in exercising voting rights, establish enhanced voting guidelines, and disclose voting results. In order to become "activist" shareholders, life insurance companies need to have an organizational structure under which funds management operations are independent from insurance policy sales operations, and proceeds with the disposal and concentration of their shareholdings.

Although this may be a surprise for some readers, the third candidate is mega banks. Traditionally, ensuring the collectability of loans and maintaining business relationships with customers were main motives for banks' shareholdings. More recently, however, mega banks have become far more selective, applying stricter criteria in choosing investee companies. Specifically, they have set out policies to: 1) select investee companies based on their profitability and growth potential; 2) consider whether an investee company has an appropriate corporate governance system properly in place as one factor in deciding on the exercise of voting rights of shares held for non-investment purposes; and 3) keep the possibility of selling shares in a company as a choice when they do not agree with the company's proposals.

In the case of listed companies with relatively small market capitalization, the percentage of those in which their leading creditor banks hold more than 3% of shares remains as high as about 30%. If mega banks strictly apply the above policies to those investee companies to which they are a block holder, it may have a significant impact to promote corporate governance reform.

>> Original text in Japanese

* Translated by RIETI.

May 30, 2016 Nihon Keizai Shimbun

July 27, 2016