As the social norms related to the purpose of companies have changed significantly, the approach of placing emphasis on stakeholders has become more prevalent worldwide. In the past, it was expected that the world would converge toward the U.S. model of governance, which advocated the maximization of shareholder value as the purpose of companies. But in fact, the Anglo-American world is now tilting toward a stakeholder-focused model.
On the other hand, in Japan, companies were exposed to the new global trends exactly when they were reorganizing their governance arrangement as a part of the reforms of the Shinzo Abe Administration, which were intended to realize corporate growth through the strengthening of shareholder primacy. Which direction should corporate governance in Japan take?
In contrast to the United Kingdom and the United States, where there is growing concern related to the overly strong governance by shareholders, in Japan, the continued weak governance by shareholders is regarded as a crucial problem. This is presumed to be the cause of the internationally low level of return on equity (ROE), lagging business restructuring, and overly conservative management. What Japan's corporate governance reform has aimed to do is to resolve these problems by strengthening shareholder engagement and reforming boards of directors.
However, the reform has been unable to realize that vision sufficiently.
According to my joint study with Keio University Associate Professor Takuji Saito, although the ROE rose during the period of the Abe administration, the degree to which the corporate governance reform uniquely contributed is negligible (see the table below). Moreover, during that period, asset turnover rate declined, meaning that there was no progress in the reduction of asset holdings. Nor is there any evidence to indicate that the corporate governance reform promoted physical and/or research and development (R&D) investment. On the other hand, contrary to the expectations of the Abe Administration, companies paid off their debts and increased cash holdings as a response to the reform. The only clear change was an increase in returns to shareholders, including dividends and share repurchases.
Source: Hideaki Miyajima and Takuji Saito, "Corporate Governance Reform under Abenomics"
Nevertheless, we believe that reform measures for strengthening shareholder primacy remain vital. The reform in Japan, which started behind other countries, is still on only half complete, while the negative effects of increasing market pressure such as short-term profit-driven myopia, have been minor compared with the United Kingdom and the United States.
The task for Japan's corporate governance reform is therefore to realize technological innovation and economic dynamism by increasing emphasis on the role of the stock market without falling into the trap of short-term profit-driven myopia and to create a framework for companies to internalize the critical social values and sustainability. In other words, the goal is not to move simply closer to the U.S. governance model or to revive the traditional Japanese model, but to newly design a "Japanese model 2.0." It would be a hybrid of those two models. Below, we will set out the challenges that must be overcome in order to pursue this third way.
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First, it is necessary to redefine the purpose of a company (the reason why it exists). The stakeholder-focused model that is currently being advocated in Japan requires that managers do more than just maximize long-term corporate value or give due consideration to stakeholders' interests.
That model is harmonious with the approach of placing emphasis on stakeholders that has been embedded in Japan, but it is not necessarily identical. The traditional Japanese model just focuses attention on the employees, creditors and communities that are directly involved with companies, and the main issues are the distribution of value-added between shareholders and employees, and toward business restructuring.
However, the redefined purpose of companies under the new model is to preserve the environment, resolve inequalities, and strengthen social inclusion, implying that profits are not necessarily attributed to the companies that commit themselves to those activities. The stakeholders of a corporation include increasingly various entities that are affected by corporate activities, including global citizens, the natural environment, and future generations. In that sense, the traditional Japanese model, which centers around regular employees, is insufficient to address global challenges that companies faces, so it is essential to redefine the purpose of companies in a way that internalizes appropriate social values and the impact on future generations.
The design of the new Japanese model also includes the further arrangement of board structures in line with the revised Corporate Governance Code.
First, strengthening the monitoring function of boards of directors continues to be an essential task for Japanese companies. However, note that reforming boards of directors and appointing more independent directors are not fix-all measures. In particular, the extent to which board reforms are effective in encouraging corporate investment and enhancing risk-taking is not yet clear. In order to make Japanese companies more dynamic and innovative, it is necessary to take complimentary measures in addition to board reforms, such as reorganizing employment system and enacting other policy measures, including tax reforms.
Second, boards of directors have an important role to play in guarding against myopic pressure of capital markets and coordinating the conflict of interests between shareholders and the newly defined stakeholders. Conflicts of interest are not exceptional, but rather normal. Selling business divisions, raising funds through debt instruments, reducing cash holdings, and increasing dividend payments and share repurchases may improve corporate efficiency in some cases, but may end up merely transferring wealth in other cases. Boards of directors, especially independent directors, should act as umpires or judges when faced with proposals from activist investors. The redefined purpose of companies could serve as the main criteria for mediating such conflicts.
Third, the new challenges require boards of directors to be involved in the processes of setting strategies of social sustainability and ESG (environmental social and governance) investments. Thus far, the diversity issues of boards of directors have been narrowly addressed as gender and nationality issues. However, expertise in environmental problems will be an indispensable skill for directors. It will become important to have the participation of experts in issues such as climate change, biodiversity, preservation of natural capital, and realization of a recycling economy in boards of directors.
The new Japanese model should also be supported by an ownership structure comprised of portfolio investors pursuing financial returns and block shareholders with long-term orientations. The presence of both institutional investors engaging in active investment and activist investors makes it possible to increase the supply of capital and reduce the cost of capital. On the other hand, the presence of such block shareholders supports the societal commitments of companies.
With respect to this hybrid ownership structure, I would like to emphasize the following points in relation to the current policy debates.
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First, actively managed funds and activist investors are often criticized for exerting myopic pressures on companies, but their efficacy has been growing in recent years. Foreign investors' investments have now spread to small and medium-capitalization enterprises, so their selection (cherry picking) and exit has begun to play an important role as a corporate governance mechanism. The involvement of domestic and foreign activist investors is exerting pressures which promote the reform of boards of directors and changes in financial policy.
Second, while the relational shareholding, and in particular, the cross shareholding among firms, should be reduced, the shareholding of corporations should not generally be prohibited. It is clear that mutual holding of small amounts of shares among companies would result in governance problems (entrenchment of top management) and should be resolved. However, block shareholding of corporation, including the case where a firm held the majority of another firms shares (so called listed subsidiary companies), as well as block holding by founders and their families, makes it possible to manage the business from a longer-term perspective, bolstering the stakeholder-focused purpose of companies. However, to ensure that this role is played appropriately, a monitor who is entrusted with the interests of minority shareholders could be delegated to an industrial corporation as a block shareholder. Within this framework, industrial corporations are expected to exhibit a greater accountability of shareholding than before.
Third, as is the case in the United Kingdom and the United States, the presence of universal investors such as passive index funds which are based on pension funds for future generations is expected to provide more promising results in terms of being longer-term investors than the block shareholding of corporations.
The shift of assets among institutional investors from active to passive funds is taking place in recent decades. In general, passive funds have less incentive to be involved in improving individual companies' management policies and governance problems. On the other hand, they have a strong incentive to reduce the systemic risks faced by the market and society. From the perspective of a share-ownership structure that is relevant for companies to make a long-term commitment to resolving global challenges and other goals, the growth of institutional investors is expected to become an important key for "Japan's Model 2.0."
* Translated by RIETI.
September 7, 2021 Nihon Keizai Shimbun
