010: Disclosure of Individual Executive Compensation and the Restructuring of Japan's Corporate Governance System

XU Peng
Faculty Fellow, RIETI

Professor of Economics, Hosei University

As was the case in the United States in the early 1980s, there are calls both at home and abroad for corporate governance reforms in Japan. This comes against the backdrop of the inability of most shareholders to recover their investments during the decade or so since 1990. In addition, the Anglo-Saxon style of corporate governance such as the inclusion of outside directors and the granting of stock options is not only having a major influence on corporate governance in Europe and Japan but also in China. In this column, I would like to review the arguments regarding corporate governance and stress the importance of the disclosure of individual executives' compensation as a keystone of corporate governance reforms in Japan.

Corporate governance should be understood as being the total framework of laws, systems and markets that guarantees that outside investors can recover their investments. We cannot ignore the fact that while there are some excellent Japanese companies such as Toyota Motor Corp. and Kao Corp., there are also numerous firms that were unable to swiftly decide to abandon unprofitable businesses. So, what sort of corporate governance is effective in ensuring that shareholders can recover their investments? The keystone of corporate governance is how management commits itself to guaranteeing to the market that investors can recover their investments. Judging from this, it can be said that providing management with incentives in the form of performance-linked compensation is the most important key to corporate governance.

Many people think of corporate governance as a system in which someone oversees management. But who hires the people who watch over executives? In the end, it is management that hires their overseers. At least at the time of the introduction of the "company with committees" style of corporate governance, it is the chief executive officer or company president who selects outside directors. This is not only because an unspecified number of small shareholders cannot effectively monitor management, but also because even such matters as deciding executive compensation and selecting and dismissing directors are often beyond the functions of shareholders' meetings. The CEO has great influence in selecting outside directors. This fact has already been proven in the United States. Therefore, the decision of whether a person with the ability to oversee management is chosen to be an outside director - in fact, even the decision of whether outside directors should be allowed to monitor management - is decided by the single word from a CEO or president. For example, if management wanted to take the teeth out of the functions of outside directors, it could form an interlocking directorate, just as with cross-shareholding, or hire outside directors who are extremely busy because they concurrently hold many posts. On the other hand, management can commit itself to galvanizing the functions of outside directors through such means as hiring people who speak their minds, or giving them stock options so that they may speak out more freely, or removing outside directors who are simply "yes-men." In the end, it all depends on whether executives are motivated to make such a commitment.

The argument of who can act on behalf of shareholders and oversee management often goes round in circles without getting anywhere. For example, outside directors need to be given appropriate incentives to motivate them to monitor management, but it is unrealistic to create another entity to oversee such outside directors, as it would result in the infinite enlargement of the corporate organization. Of course, if management were to be allowed to oversee the outside directors, it would result in the monitored watching over those who should be monitoring them. The same reasoning applies to the argument of executives deciding on their own compensation. Under Japan's Commercial Code revisions of 2002, if a firm adopts the ``company with committees'' structure, the amount of compensation for its directors and executive officers (and how it should be awarded) are decided by a compensation committee, comprised by a majority of outside directors. On the other hand, because outside directors should not be able to set their own compensation, in the end the president or other directors decide on remuneration for these outside directors. If this is the case, then naturally, the independence of the outside directors would be called into question-their role is to decide compensation for those who set their own remuneration.

What I would like to stress (so that this argument does not go round in circles) is that the starting point for the construction of effective corporate governance is to provide management with incentives through performance-linked compensation. Such incentives are formally decided at general shareholders' meetings or by compensation committees composed of a majority of outside directors. But in fact, this compensation is a commitment made by management to the stock market, and not something that someone can decide. Because of this, compensation agreements that include performance-linked remuneration are as important to investors as financial statements. Information regarding individual compensation for presidents and CEOs is especially important. Because the U.S. Securities and Exchange Commission is well aware of this, it requires the disclosure of such information as 1) a summary compensation table, a corporate performance table and a comparison between performance and industry benchmarks; 2) a table showing the individual annual and long-term compensation amounts awarded to the chief executive officer and the next four highly-compensated executives; 3) the estimated value of stock options and 4) the compensation committee's setting and reporting of the qualitative and quantitative benchmarks for management evaluation. Information regarding executives' transactions of their own company's stock is also disclosed in detail, and can be viewed at any time on the Internet.

Since 1997, the granting of stock options has taken root in Japan. This is an indication that the importance of making executive benefit and shareholder benefit coincide through stock price-linked compensation is gaining greater recognition as Japanese corporate governance shifts from the traditional relationship-oriented style to one that is more market-oriented. Performance-linked compensation such as stock options are a commitment to investors and the stock market, and is one of the most important mechanisms to guarantee investors, especially stockholders, that they will be able to recover the money they invest. In addition, the introduction of stock options has provided the opportunity for Japan's top managers to take more notice of stock prices, and it is possible that this may accelerate moves to buy back shares or reduce cross-shareholding in an effort to boost the price of their company's stock. In this regard, the introduction of performance-linked compensation has become the first step in the shift from the relationship-oriented style of corporate governance to market-oriented corporate governance.

However, the traditions and precedents regarding executive compensation - namely, that it is sufficient to just have a general shareholders' resolution that sets the ceiling for the total amount of directors' compensation - still hold sway, and most Japanese firms only disclose the total number of stock options given to all their directors. In recent years, the number of shareholders who are speaking out amid the decline in business performance at Japanese firms is increasing, and calls are mounting for greater transparency on the part of companies. One sign of this is the rise in the number of shareholders' proposals demanding disclosure of the retirement benefits and compensation of individual executives. For example, at Sony Corp.'s general shareholders' meeting held on June 20, 2002, a proposal from shareholders calling for the disclosure of compensation for individual executives was voted down, but judging from the fact that 27 percent of votes were in favor of the move, shareholders' interest in individual compensation can be said to be increasing. Furthermore, according to the 2002 White Paper on Shareholders Meetings compiled by the Commercial Law Center, Inc., more foreign institutional investors are voting against such matters as the opaque way in which executive compensation and retirement benefits are decided. This shows that the disclosure of individual executive compensation is not simply something that some individual investors are seeking just out of curiosity but something both foreign institutional investors and individual investors are showing interest in. This is because foreign institutional investors are well aware of the importance of information regarding compensation for individual executives.

Traditionally, the number of shares a director holds in the company is disclosed in Japan. If this is the case, then there is no reason why information regarding the stock options held by individual directors cannot be disclosed. From the viewpoint of incentive, it is insufficient to just disclose the compensation ceiling for executives in advance and later disclose the total amount paid. Information regarding compensation of all executives should not be given on aggregate, but thoroughly disclosed on an individual basis, for example by limiting it to those who have top executive authority such as directors with representative rights or the chairman, president and vice president. This is the keystone for the creation of market-oriented corporate governance. Furthermore, in the case of companies with committees, whether the firm discloses the individual compensation for its top five executives can be a test to see whether outside directors are serving as a watchdog for investors or simply a group of yes-men. Of course, securities exchanges should also set rules regarding the disclosure of compensation for individual executives. At the same time, the corporate tax system should be revised so that, as in the U.S., the disclosure of individual compensation is a condition for allowing executive compensation and executive bonuses to be counted as costs.

June 16, 2003

June 16, 2003

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