007: Current Situation and Problems concerning Corporate Governance in Japan

In line with revisions to the Commercial Code that will take effect on April 1, corporate governance in Japan will change from what is has been up to now. Plainly put, three options become possible - (1) traditional corporate governance centering on the executive board and statutory auditors, (2) the so-called Western style or American style of governance which centers on an audit committee and some other committees while outside members form the majority of the board and (3) a style somewhere between these two.

For the time being, the main points of discussion in Japan are how to set up a system of governance that includes the executive board, the audit board, the audit committee and internal audit systems. Related issues concern what role outside board members should play within the executive board and what role outside auditors should play within the audit board. Also, unfortunately, over the past one or two years, there is also debate over very basic issues such as compliance and observance of the law in the wake of some corporate scandals.

In this context, Keizai Doyukai's Committee on Corporate Management chaired by IBM Japan Chairman Kakutaro Kitashiro released a report last July entitled "Corporate Governance Reforms That Aim to Strengthen the Foundations of Corporate Competitiveness." (*1)

The report proposes corporate governance that aims to strengthen the basis for corporate competitiveness. Its basic viewpoint is that corporate governance at Japanese firms must change dramatically if Japan's economic competitiveness is to be maintained and if corporate competitiveness is to be kept at international levels or above average levels.

There are two main points to the report. First, a clear distinction is needed between execution of operations and supervision. In other words, the role of the board or board members should clearly be supervision in order to refine the role of the board. Second, the assessment of the management team should be properly incorporated as a part of supervision. If and when the board determines that the current management team cannot continue to produce results, then it can change the team. Such a system should be more clearly incorporated into Japanese corporate governance.

So long as the traditional system based on the idea that in reality, the management team assesses itself, teams cannot be changed swiftly in line with the circumstances. The report suggests that this is one reason why Japan is losing its competitiveness, especially internationally, and that a system is needed in which a committee whose majority is comprised of outside board members makes assessments and decisions.

Furthermore, although this proposal is close to the American style of corporate governance, the report also notes that long-term shareholder profit is more important than maximizing the short-term profits of shareholders. Of course, this does not mean that we deny the existence of shareholders whose aim is short-term speculation, but corporations should not be run for the benefit of such shareholders, but should be managed with the long-term returns to shareholders in mind. As a result, there is no choice but to lean toward stakeholders' thinking rather than shareholders' thinking. The report suggests that the specific framework for this style of corporate governance should be introduced step by step, such as establishing advisory boards and executive officer systems.

As for outside board members, there is much debate in Japan on the issue. But it seems that there are strong negative opinions, such as "there aren't that many people who are appropriate to serve as outside directors," or "no matter how great they may be, it is unpleasant to have a person with no knowledge of this firm to meddle in its affairs." However, it is very risky to run a firm solely based on the views concerning one company, and in order to objectively assess a company's management, I would go so far as to say that outside directors are indispensable. Even if they have no detailed knowledge of the inner workings of the company, they can open management's eyes to what is going on in the industry as a whole, as well as in other industries. Thus, they provide a more compound view. The report also proposes that the number of outside members be increased gradually, rather than mandating a majority from the outset, as is the case in the U.S.

In another report that is to be released in March, the starting point is the basic and universal issue, "Why do companies exist, and for whom do they exist?"

Basically, it can be said that companies exist to be useful to society, or social needs. If it were asked, "For whom do companies exist?" we can say that they exist for people whom the firm must clearly recognize, such as stakeholders - those who have interests in the firm and are directly or indirectly connected to its management.

It is true that in reality, the realistic view that there is no choice but to focus on stockholders and maximize their returns is strong. But in Europe, the idea of corporate social responsibility (CSR) is being discussed seriously. Furthermore, the principal business of companies - profit-making - is taken into account in much of these discussions, and the idea is also starting to be put into practice.

Keizai Doyukai is now drawing up a "Corporate White Paper" based on its inspection trips and surveys in Europe that look at CSR at the corporate level as well as socially responsible investment in firms that actively embrace CSR. Keizai Doyukai itself plans to introduce a quantitative index to measure CSR once its significance is confirmed after a trial period. By taking a quantitative approach, CSR can be a useful tool in actual corporate management. Once that happens, we will have to view CSR as a corporate governance issue, and then it will be only natural, for example, for people from various sectors of society to participate as outside board members.

It is a fact that Japan's competitiveness has fallen considerably in international comparisons, and naturally, there is the problem of having to offer high returns to investors to ensure that enough capital is secured to run the company.

However, when we look at the phenomena in the U.S. and Japan in recent months, I believe we should not lightly brush them aside as mere scandals but think of them as serious issues regarding ``Why and for whom does a company exist?'' More broadly, we can ask whether our current and past actions have sufficiently lived up to society's trust in companies? If we are to understand corporate governance as a way of thinking and a system necessary to maintain social trust at a constantly high level, then we must not stop at just discussing systemic aspects but also properly debate the "way of thinking" aspect of the issue.

From the end of World War II to about the 1970s, Japanese management had a mix of young people who returned after seeking to absorb new postwar ways of thinking in the West and leaders who received an education that encompassed many things - general education, the humanities, and of course history, philosophy and religion. This combination resulted in management balanced between the advancement of corporate management through the utilization of superior management abilities or technology and "aving the moderation to balance such moves."

However, in present-day Japan, management - from top leaders to actual workers - is in the hands of people who received so-called technical education, or the "how-to" education of the postwar period. Under such management, matters as how to achieve necessary moderation or whether the market shall have the final say become very serious and troublesome issues.

To conclude, I believe that management should not leave things to the market because there is no other choice. If individual executives cannot make such moderation possible, then several people can through lessons learned from other firms. Once again, the existence of outside board members should be recognized as one important way to achieve this. At the same time, management must not distance itself from real operations. This is especially important for functions such as auditing. I believe that outside auditors should be added to auditing boards and outside board members to executive boards. Through such a combination, management is provided with a compound view and auditors do not distance themselves from daily operations. The issue of realizing these two points deserves more attention when discussing future corporate governance.

March 17,2003

* This text is an abridged version of a speech given at the RIETI policy seminar "Corporate Governance from an International Perspective: Diversity or Convergence," held on January 10, 2003 at the United Nations University in Tokyo. The event was co-sponsored Japan Association of Corporate Executives and the Japan Association of Corporate Directors.