008: Establishment of the "company with committees" and Corporate Governance

One can say that the year 2003 was a revolutionary year from the standpoint of corporate governance. Until then, many called for corporate governance to be debated by a wide range of interests in order to come up with a Japanese type of corporate governance that takes into account the characteristics of our country. While this argument is legitimate, the manifold nature of corporate governance led to procrastination of concrete measures to address the matter. But now, a systemic revision of corporate governance has finally been achieved. Announcements of the adoption of this new system by companies such as Sony, Orix, Toshiba and Hitachi, are still fresh in our minds.

Many claim that the new "company with committees" proposal is based on the US system. While a lot can be learned from the US, the new system is not a direct import. Rather, we have learned and adapted certain features of the US model to the Japanese style. The outline of the "company with committees" system is as follows. A large company can revising its articles of incorporation to explicitly chose this system. In a "company with committees," three committees need to be set up where more than half of the directors are outside directors: an auditing committee, an appointment committee and a compensation committee. Officers will replace corporate statutory auditors and the representative directors. The executive officer will represent the company. Meanwhile, directors will not be involved in operative management. Rather, the board of directors must decide the basic management principles of the company as well as the framework for its internal control system. If this internal control system is deficient, this will be recorded in the audit and the shareholders will decide on the replacement of the director. In regard to operative decision-making, a more limited set of issues will require the vote of the board of directors than under the statutory auditor system. Thereby, power is substantially decentralized to the officers. The tenure of the director and the officer will be one year, and their liability will be reduced provided that they act in good faith and without serious negligence. The board is also responsible to vote on the appropriation of profit and disposition of losses.

There appears to be some misunderstanding about this "company with committees" system and I would like to comment on several common misconceptions. Nonetheless, I do not believe corporate governance would ever be perfect based on legislation alone.

First, while outside directors play a key role in a "company with committees," such outsiders are generally viewed as not understanding the company. This opinion lacks understanding of the basic principle of a joint stock corporation (kabushiki kaisha) where the separation of ownership and management is a prevalent. A corporate director is selected by the general meeting of shareholders. He or she has the duty of care and must be faithful to one's duty, as well as be accountable to the shareholders. Even if one continued to manage a company with an attitude of "they won't understand anyway," if that company ultimately went bankrupt and had to go through liquidation, the shareholders would be treated with the lowest priority. There were voices calling for "the shareholders to first bear the burden" in the debate over the disposal of bad loans, but if they are to be the ones to bear the most responsibility among stakeholders, then the system must give shareholders effective influence before the company faces a crisis. This is not a simple matter of "those with an exit need no voice." While an outsider may not be acquainted fully with the workings of the company, by respecting their opinions, one can avoid being opinionated and hence improve accountability. Whether one likes it or not, one must be able to explain decisions and strategies to relevant outsiders.

Second, many people argued that it is possible to set up committees and officers (as well as make other necessary adjustments) under the current company law, and that the three committees required by the new system merely make the company more rigid. But committees under the conventional company system are merely advisory organs. In other words, the decisions by advisory committees must be voted on by the board of directors or approved by the representative director. Hence, the board of directors or the representative director can overthrow a decision by the advisory committee. Moreover, advisory committee members have no legal responsibility. From the standpoint of transparency, an advisory organ whose decision can easily be overruled is completely different from a committee under a "company by committee."

Furthermore, the officers of a "company by committee" have their tenure, responsibilities and duties defined clearly by law. The "company with committee" system secures transparency by constructing this scheme based on the three committees for the critical supervisory functions. The three committees are mandatory in that they serve to divide the supervisory and execution functions. If this critical criteria point is fulfilled, the system actually allows for much flexibility in company structure. As mentioned earlier, fewer require a vote of the board of directors, but the company may still decide what authority it delegates the officer in execution of business affairs of the company. While consultation with executive officers is legally required, consultation can be made on matters which would be truly worth debating without slowing down the decision-making process. And depending on the issue, it is fully possible to say, "these sorts of matters are decided by the representative officer alone, and these other matters require consultation with officer A and officer B." The law aims that each company use its imagination to come up with effective internal control practices--internal audits, reporting of internal audits to the audit committee, and measures to prevent these works from being abused in personnel matters by taking into account the progress of audit methodology. In actuality, it is difficult in large companies for a limited number of people to oversee and make sure effective and proper management is being conducted, and it is necessary to create an effective system for internal control. While it is not mandatory to appoint a full-time director to organize the audit committee, obviously, it is possible to have such a full-time person run the operation.

Third, I would like to touch upon views that abolishing corporate statutory auditors will compromise auditing functions. The audit committee or the director organizing the audit committee has the same authority as corporate statutory auditors. In other words, the committee and director have the right to conduct investigations and the right to request injunction for illegal acts. While a corporate statutory auditor can state opinions before the board of directors if legally questionable operations are discovered, the statutory auditor has no voting right. If the project related to such questionable operations is approved, the only alternative is to request an injunction. But in a "company with committees," it will be possible to spot problems with the support of the internal control system on a day-to-day basis and to make efforts to resolve the problem by exercising voting rights before the board of directors to prevent or remedy problematic projects. The committee is ultimately involved in the reelection of the operating officer, while still possessing the right to request injunction. Hence a "company with committee" can take full advantage of the talent and operational skills acquired by the auditors in conventional companies. Thus, I find it hard to understand the arguments that posit a confrontational position toward the corporate statutory audit.

Fourth, many have argued that (1) since it remains was possible to serve as both director and officer and (2) it was not mandatory to have the majority of board be outside directors, that the separation of the supervision and management will be insufficient. Literally speaking, a complete separation of supervision and administration would require banning plural office. While this sounds ideal, this separation would make it difficult for information on management to reach the supervisory body, thereby hampering effective supervision. That is why plural office was not fully prohibited. But since matters concerning audit, personnel and compensation are critical issues for supervision, the decision making power is given to the three committees with a majority of outside directors. In other words, the committee system aims to balance of objectivity and flow of information. While it is not mandatory to have a majority of outside directors, but this considers the situation in Japan where even a third of outside directors on the board have considerable impact. In any case, since the board members will be selected by the majority outside nomination committee, the majority of the board is likely to also be from the outside (actually, companies planning to adopt the "company with committees" system plan to have a majority). Even if a majority does not result, authority over critical supervisory matters pertaining to audit, personnel and compensation will nonetheless be in the hands of the three committees. Whereas statutory auditors must be elected by the board, a candidate for director with a supervisory role in a "company with committees" is decided upon by the appointment committee with a majority consists of outside directors.

Next, I would like to comment on the so-called issue of corporate governance often discussed in relation to the question of "company with committees."

Corporate governance is often debated in the context of the old question: Who owns a company? "A company belongs to the shareholders" is said to be a US-style company, while "a company belongs to the employees" is said to be a Japanese-style company. In the 1980s, the long-term oriented Japanese model was touted to be an ideal, while the US model was seen as negatively seeking short-term profits through M&As. This argument implicitly suggested that the silent shareholders created by the Japanese cross shareholding system made it possible for companies to seek long-term profits. But in recent years, praise for the US management style increased as the US economy improved relative to Japan. Meanwhile, some commentators cling onto past successes and call for a reevaluation of the Japanese management style of the past. How should one deal with this issue?

Notions of "ownership" which often arise in this debate tend to be vague. My view is as follows. The relationship between a joint stock company and the director appointed by the general shareholders meeting is to comply with the appointment relationship. Meanwhile, the executive officer selected by the board of directors represents the company and enters into an employment contract with the employees. In other words, a stock company (and the executive officer representing the company) serves as a nexus of various contracts such as an appointment contract with shareholders, employment contract with employees, lending contract with banks, and a sales contract with outside firms. This fact remains unchanged whether we consider Japan or the US. The productive activity of a company arises through the effects and counter-effects of these various contracts. Since it is impossible to make written provisions for every possible contingency, costs may arise from any contract, and chances are that the shareholders who bear the final risk as residual claimant will have to bear the largest cost. Hence, the relationship between the shareholders and the company is most scrutinized as an issue of corporate governance.

Viewed in this way, it is fruitless to debate whether a company "belongs to the shareholders" or "no, it belongs to the employees in Japan." Since a company is a nexus of various contracts, both Japanese firms and US firms "belong to shareholders" and "belong to employees." A company in which the appointment contract is frequently changed and the employment contract is frequently changed because of the frequent change in the executive officer, is called the "US-style." And a company where such changes in appointment and employment contracts are difficult to make is called the "Japanese-style." How a company functions depends on the substance of these various contracts. In other words, how the appointment contract works (in other words, the capital market), how the employment contract works (in other words, the labor market), and how the loan for consumption works (in other words, the financial market), determine how a company operates and serve to supplement the system. In Japan, some say "governance by shareholders is unnecessary because governance by employees is functioning." But a prerequisite for governance by employees is based on the fact that if an executive officer continues a project seeking only private benefit, the company will lose the support of the capital market and will not benefit the employees. In this sense, the capital market and the labor market compliment each other.

Maybe the reason a "Japanese-style" company was favored is because their arrangements were well suited to compete in industries where incremental improvements result in advantages in quality and global competitiveness, rather than industries based on strong innovative discoveries. As it is difficult to make changes in the substance of the various contracts with the company as junction, it is also easier to think in a longer time span. But in recent years, industries have appeared where this improve and revamp style of technology has reached a point of saturation have. Today, a stronger demand exists for industries where competitiveness is based on creativity, discovery and quick response to consumer needs at a low cost. And hitherto known market arrangements may not be suitable for such an industry. Put simply, if we take the example of a manufacturing company, the best system results from a good match between the product architecture of a certain industry ("modular type" or "integral type") and the institutional arrangements for corporate governance in that industry. In other words, neither the "US" or "Japanese" type are superior. The real question is whether the product architecture creating industrial competitiveness matches the arrangement of the markets in that industry. In industries where competitive advantage is based on conventional "integrated" type of architecture, we can claim that "the Japanese style management is best, and the company belongs to the employees." In those belonging to industries seeking newer "modular type" architecture claim "the US style is best." Hence, the ideal form of corporate governance, while it may not be easy, is to construct arrangements appropriate for the type of operation.

If the ideal form of corporate governance is to seek the most appropriate form of the business category, what role should corporate legislation play?

Based on the analysis above, an ideal system would depend on the sectoral or company-specific factors. Hence, the law should not unilaterally impose a particular system, but should leave room for voluntary provisions. For example, many argue that since there is no ban on appointing outside directors, it should be left to the interested parties and self-governance based on the articles of incorporation. At first glance, this argument sounds agreeable to the recent trend of deregulation, but I do not believe this logic is relevant. Even if the coordination was left to the parties concerned, the problem of asymmetry of information and the existence of transaction costs must be taken into consideration. One may argue that the shareholders are the most important, hence the interested parties among the shareholders will voluntarily create the most desirable mechanism, but one must consider the cost involved in voluntarily constructing such a system, and one cannot avoid the problem of collective action. Furthermore, one may argue that since funds will invest in corporations with "good" corporate governance, one can ultimately leave it up to self-governance. But the investors will have to pay the cost of searching for firms with "good" governance arrangements, and asymmetric information increases the probability of investing in "bad" companies (from the point of view of the shareholders). Seeking private benefit may simply be more beneficial to managers than the profit acquired by making "good" proposals. In order to avoid such circumstances, the law must interfere in the coordination of interested parties to a certain degree. That is the significance of providing for supervisory mechanisms in the Commercial Code. That is the reason why foreign countries also make efforts to improve their legal provisions for supervisory functions and the effort continues today. It is naive to argue that the best system will be created if left in the hands of the market, and one should consider how to design the system by taking into account the problem of information asymmetry and transaction costs. Thus, I believe the current legal reforms were highly appropriate in legally supporting the "company with committees" system, but allowing a room for choice between it and the existing company structure.

Viewed in this way, the "company with committees" style can promote a shift to a more desirable arrangement for industries which are superior in their creativity, have a knack for discovery and are swift in its response to consumer demands at low cost. Furthermore, it may serve a useful function for older and more integrated types of industries as well. Generally, the attempt the agency costs to shareholders is desirable, regardless of whether one pursues a "Japanese style" or a "US style." It is inappropriate to single-handedly argue that such moves will "enhance the violence of shareholders who do not understand anything about the company."

Of course, it is understandable to say that if the executive officer is frequently replaced and layoffs are frequent in an "integral type" industry, then the competitiveness of the industry will be undermined. But to prevent such from occurring and have the entrepreneur aim for a long-term management should not be guaranteed by providing legislation where the shareholders face higher agency costs. It is unthinkable to secure long-term profit by offering a message to the shareholders such as, "Dear shareholders, it will be to your benefit under the current system if we do not designate an effective supervisor and tie your hands in order to secure your profit." Management strategy should be improved by trying to secure long-term profit under pressures of lower shareholders' agency costs. Otherwise efficacy would be sacrificed and wrongly excused in the name of pursuing long-term profit. Without such "pressure," a risk exists of adhering to the wrong long-term management strategy. While long-term management strategy is argued to protects the jobs, it also results in having the employees acquire an expertise applicable only in the company behind the message: "Treasuring the employees." When such a company beings to fail, they cannot take care of the employees who have acquired an expertise applicable only in the company. This result cannot truly mean treasuring the employees.

If management strategy should be constructed under investor "pressure," needless to say there should be a lot for the interested parties to discuss in regards to the question of "what is the desirable form of corporate governance for our country" even if the system has been laid out. I sincerely hope that several years from now we can say that our serious debates have resulted in new innovations in the forms of corporate governance. I would like to conclude this paper with my determination to do continue my efforts in this endeavor.

May 30, 2003