Column 3 - Unwinding of Cross-Shareholding and Beyond

NITTA Keisuke
Strategist, NLI Research Institute

Cross-shareholdings used to be viewed as a distinctive characteristic of the Japanese stock market. The ratio of such cross-held shares expressed as a percentage of the market capitalization (hereinafter cross-shareholding ratio) stood at around 18% throughout the late 1980s to mid 1990s, even when limiting cross-held shares to those of a strictly reciprocal nature, according to the Survey on Cross-shareholding conducted by NLI Research Institute. This indicates a quite significant presence of interlocking shares during that period. Subsequently, however, such cross-holding relationships have diminished rapidly. The cross-shareholding ratio fell to 7.6% as of the end of March 2004 and is estimated to remain at about 7% (a provisional estimate). Thus, the importance of cross-held shares in Japan's stock market has substantially decreased. But does this signal the end of the role of cross-shareholding?

Shrinkage and resurgence of interlocking shareholdings

This point can be examined by looking back on how cross-holding relationships have developed and declined in Japan. The practice of cross-holding of shares began to develop between banks and their client companies as a countermeasure against accumulation of shares, which became easier due to the emergence of dispersed shareholders following the postwar dissolution of the zaibatsu conglomerates. That is, cross-shareholding's initial role was to defend against takeover bids. Subsequently, the complementary relationship strengthened between cross-shareholding and other management characteristics of Japanese companies such as the lifetime employment system, management teams consisting mostly of internally promoted managers, and long-term and stable relationships with banks and client companies. Thus cross-shareholding developed as a factor of the Japanese corporate system in the postwar, high-growth economy.

This unique stock ownership structure of Japanese companies, however, reached a major turning point when the nation's economy slowed and the economic bubble burst. In the latter half of the 1990s, many Japanese companies became unable to maintain such traditional management and business practices as lifelong employment and long-term stable business transactions as before. Furthermore, as the debate on corporate governance intensified, the practice of cross-shareholding was heavily criticized because the presence of cross-held shares prevents the rise of shareholders threatening to take control of management, and thus inhibiting discipline of corporate management. Not only did this weaken the complementary relationships between cross-shareholding and other factors of the corporate system, but cross-shareholding came to be defined as a factor weakening the discipline of management and impairing shareholder value.

Falls in share prices in the latter half of the 1990s highlighted the risks Japanese banks were taking by holding massive amounts of shares. Furthermore, institutional changes - such as the introduction of mark-to-market accounting and enactment of laws setting a limit on banks' shareholdings - came as additional constraints. Against all these developments, banks embarked on a massive unwinding of cross-shareholdings. Thus, the rapid closure of cross-holding relationships observed since the late 1990s was brought primarily by banks' disposing of shares.

As a result, cross-held shares are no longer conspicuous in today's stock market. However, cross-shareholding is thought to still have a role. Though the ratio is declining, nearly 80% of listed companies in Japan still maintain some sort of cross-holding relationships. The current state of affairs sees Japanese companies opting for continued holding of shares in key business partners as a token of commitment to long-term, stable, inter-company relationships even though they have reduced the overall scale of cross-held shares.

Some Japanese companies are moving to revive cross-shareholding to defend against an expected increase in hostile takeovers as well as for the planned easing of rules to allow triangular mergers. The original function of cross-shareholding is thus gaining renewed attention. Yet this is occurring only with specific industries exposed to hostile takeover threats; the extensive cross-shareholding of the 1980s will not be revived. The ongoing moves to strengthen cross-shareholding ties, observed in certain business sectors, are viewed as being primarily intended to signal the presence of a white knight.

Newly emerging trend of stock ownership structure

As discussed above, even though cross-shareholding has not completely lost its role within the corporate system, it has been substantially decreased and the presence of cross-held shares in the stock market has already diminished. Yet, at the same time, the trend of increasing numbers of family-controlled companies has emerged. Generally speaking, Japanese companies - like those in the United States and United Kingdom - have a widely dispersed ownership structure characterized by the absence of controlling shareholders. In recent years, however, there has been a clear rise in the number of companies with controlling large shareholders.

How these family-controlled companies should be identified is open to debate. For the purpose of this article, however, the degree of family ownership is measured in terms of an aggregate percentage of all shares held by incumbent directors of the companies, his or her private companies, non-directors and unlisted domestic companies holding a share of 3% or greater. Non-directors holding 3% or more shares of a company - typically founding family members, etc. - often have the power to exercise significant influence over the company's management. Likewise, most cases in which a sizable percentage of shares is held by unlisted domestic companies are perceived as a form of indirect family control. In what follows, this aggregate percentage of shares is referred to as "family owned ratio".

This article focuses on companies listed on the first section of Japan's three major stock markets - the Tokyo Stock Exchange (TSE), Osaka Securities Exchange (OSE), and Nagoya Stock Exchange (NSE). Companies listed on emerging company markets (TSE Mothers, OSE Hercules, etc.) have been excluded because most of the companies are not sufficiently mature. The family owned ratio in first-section companies generally remained around 6% throughout the 1990s but rose to over 11% by the end of March 2006. The proportion of companies with a family owned ratio of 20% or above, as a percentage of all listed companies, also increased from around 10% in the 1990s to 24% at the end of March 2006. These show that family-controlled companies have been an increasing presence in Japan's major stock markets.

New governance issues

These facts are raising new issues regarding corporate governance in Japan. In recent years the Japanese government has implemented a succession of legislative and regulatory reforms to enhance corporate governance while companies, for their part, have worked on bold reform of management structure. Yet all these reform initiatives are essentially designed to alleviate the agency problem between corporate managers and shareholders. In contrast, the rise of controlling shareholders is posing an old yet new question of what to do about conflicts of interest between large controlling shareholders and minority shareholders.

Companies with a controlling shareholder face the possibility that the shareholder might exercise influence over corporate managers to force a self-interested transaction at the expense of minority shareholders. For instance, the shareholder may force the company to transact with, and thus drive profit to, a company run by his or her family member. Such fraudulent conduct may be preventable if minority shareholders can fully supervise all the conduct of the controlling shareholder and corporate managers. In reality, however, minority shareholders rarely have this ability and even if they detect a wrongful act it is extremely difficult to substantiate it. This sort of fraud reduces the corporate value and the resulting costs must be borne by both the controlling shareholder and the minority shareholders. Yet the controlling shareholder has incentive to exploit minority shareholders if the expected gain from the transaction exceeds the cost. This problem cannot be addressed within the framework of "principal-agent relationship".

The theme of conflicts of interest between controlling and minority shareholders has recently received a great deal of attention as a governance issue faced by listed companies other than those in the U.S. and UK. At the moment, however, little is known about the costs and benefits of such ownership structure or to how to cope with its possible problems. In Japan, following the establishment of emerging equity markets, the number of listed companies controlled by their founders is steadily increasing. Also, as discussed, the presence of family-controlled companies is increasing in the established major markets. Furthermore, this theme relates to another problem within the Japanese stock market - subsidiary listings. The parent company of a listed subsidiary is, by definition, a controlling shareholder. But is this type of controlling shareholder different from that of a family-controlled company? How should the costs and benefits of controlling shareholders be understood? And what would be the impact of the type of corporate control on management action or performance? These will become major issues surrounding corporate governance in the coming years.

May 9, 2007

May 9, 2007

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