Column 4 - Latest Development in Corporate Governance

XU Peng
Professor, Faculty of Economics, Hosei University

Since the late 1990s, Japan's corporate governance has undergone drastic changes amid the prolonged recession, and efforts to search for new corporate governance models continue to this day. In this article, I would like to analyze the current state of Japan's corporate governance in the light of the United States' experience in the areas of internal control, performance-based compensation systems, the respective roles of debt and capital market pressure, and the relationships between these roles; thereby presenting future prospects for Japan's corporate governance.

Outside or independent board directors

Internal control refers to a governance system centered on a board of directors, in which the role of independent, outside directors is particularly emphasized. Under the influence of U.S.-style corporate governance, the Japanese Corporation Law incorporates provisions that allow companies to opt for the board committee system as an internal control structure. South Korea and China have also introduced outside directors as a governance system. While the Japanese Corporation Law clearly defines the term "outside," its current definition of "independent" is still somewhat ambiguous. For instance, what if a lawyer appointed to serve as an outside director for a company belongs to the same law firm as the company's legal counsel? It is not clear whether the newly appointed outside director truly qualifies as independent.

In the United States, outside directors run up against certain perceptions. First, it should be noted that chief executive officers (CEOs) are often involved in the selection of outside directors by serving as nomination committee members or holding a concurrent position as chairman of the board. In companies with a track record of high performance, an outside director is no match for a powerful, charismatic CEO. Companies with poor performance tend to appoint a greater number of outside directors. Unfortunately, an increased number of outside directors has not been found to necessarily improve business performance. This, however, should not be surprising. Indeed, if the appointment of several outside directors at the cost of tens of millions of yen improved return on equity (ROE) by several percentage points, all companies would rush to do it. In this regard, a certain top corporate manager accurately likened inside directors to an engine and outside directors to the brakes.

So what are the roles of outside directors as brakes? First, outside directors are supposed to facilitate the dismissal of the CEO and other executive officers of a poorly performing company. As confirmed by many empirical studies, the higher the proportion of outside directors, the more sensitive companies are to business performance in deciding the dismissal of the CEO and other executive officers. Another tendency is that the performance-based portion of CEO compensation is greater in companies with a higher proportion of independent, outside directors. In the following section, I would like to discuss the role of this form of compensation.

Performance-based compensation

Performance-based compensation - including bonuses to executive officers, stock options, and restricted shares linked to accounting earnings, stock prices, or other measurements of business performance - is counted on as an effective means of motivating executive officers to strive for greater accomplishment by aligning their interests with those of stockholders. Through a series of law revisions - amendments to the Commercial Code and the enactment of the new Corporation Law - since 1997, Japan has phased in stock options and restricted shares. Some studies have shown that the introduction of stock options is conducive to the management of companies. The next vital step is to empirically determine whether companies adopting the board committee system - companies that have clearly introduced outside directors - are more inclined to offer stock options, and if so, whether the greater use of stock options is resulting in improved business performance.

The unfolding of the Enron scandal drew attention to the adverse effects of stock options, namely, the inducement of accounting fraud and insider trading. Even before that, the widespread practice in the U.S. of granting stock options had been subject to controversy. In many cases stock options were reportedly granted immediately, before the release of positive news such as increased profits and higher dividends. Also, in an equally controversial, often-observed practice, some companies lowered the exercise price of previously granted stock options or, when stock prices fell, re-granted new stock options with a lower exercise price. Most puzzling to economists is the absence of compensation linked to the relative performance of companies. Subsequent to all these troubling factors, CEOs have been awarded hefty performance-based compensation not only when stock prices were up but even when they went down. Due to recent changes in stock option accounting rules to require, in principle, mandatory expensing of stock options granted to executives, an increasing number of U.S. companies are shifting away from stock options to transfer-restricted shares as a means of performance-based compensation.

The increasing occurrence of stock options offered as a form of compensation has made top corporate managers more conscious of stock prices than they used to be. However, this practice, which began to expand in the U.S. in the latter half of the 1980s, has clearly become worn out. In particular, given that many outside directors involved in granting stock options are themselves CEOs of other corporations, it is no wonder that they have little enthusiasm for introducing relative performance-based compensation; a scheme which would boomerang on them. But it should be noted that all these problems have surfaced because of a high degree of transparency in disclosure of information on executive compensation in the U.S. I will later discuss problems with similar disclosure in Japan.

Hostile takeovers

From the 1990s onward, the number and value of hostile takeovers in the U.S. has substantially declined compared to the 1980s. Major reasons behind this include reform of the board of directors system, which increased the role of outside directors to turn them into central players, and the spread of stock options. Strengthening of management incentives to maximize stock prices has resulted in a substantial decreased number of hostile takeovers targeting undervalued companies. In addition, executives have been increasingly ready to target companies that will accept a takeover bid and leave with lucrative "golden parachute" compensation.

The combination of large free cash flow and poor business performance resulting from diversification strategies was the major driving force behind the hostile takeover boom of the 1980s. So-called free cash flow refers to excess cash retained by corporations. When retained by mature and declining companies with a low debt ratio and scarce opportunities at large profit, the cash flow tends to be wasted, for instance if it is invested in and/or used for maintaining unprofitable businesses, and not used for the purpose of maximizing shareholders' wealth or corporate value. Leveraged buyout (LBO), by increasing the debt ratio of an acquired company, serves as discipline for the management, prompting it to quickly pull out of unprofitable operations and preventing investment in unprofitable projects.

It is notable that in the case of growing companies with many highly profitable investment opportunities, cash flow helps reduce capital costs and causes few problems. Indeed, from the 1960s through the mid-1980s, the agency problem arising from free cash flow was not so serious at Japanese companies. The free cash flow problem occurred in the U.S. because of the rise of the Japanese economy and the resultantly increasing number of U.S. companies in the mature and declining stages where few highly profitable investment opportunities are available. By the same token, the free cash flow problem has intensified in Japan with the rise of other East Asian economies resulting in the maturing and declining of some Japanese companies. This made certain cash-rich Japanese companies attractive targets for activist investment funds such as Steel Partners; hence the dawn of Japan's hostile takeover era. Given such developments, it is imperative to analyze, in detail and firmly based on data, the effect of hostile takeovers on corporate management.

Roles of debt

Debt takes away free cash flow from the management of cash-rich, matured and/or declining companies. This is because debt obligations, unlike dividends and retained earnings that are subject to management's discretion, must be fulfilled with both interest and principal paid strictly in accordance with the contract terms, irrespective of management's intention. Companies that undergo an LBO or management buyout (MBO) have to use a substantial portion of free cash flow for debt repayment because buyouts are primarily financed by bank loans and investment funds. In this context, LBOs and MBOs can be defined as arbitrage transactions. Likewise, hostile takeovers have an element of arbitrage that utilizes an optimal capital ratio.

The most familiar role of debt is the function of main bank. Literally interpreted, the main bank is to intervene in the management of a client company only when it falls into financial distress. Thus, the timing of intervention by main banks is late relative to the timing of intervention through LBOs and MBOs. Another weakness of the disciplinary role of debt is the bank debt enforcement's heavy reliance on loan collateral. At a time when the value of land and other collateral assets is falling with the slowdown of the economy, banks are left with no effective means to enforce their claims under the relevant loan agreements.

In the 1970s through 1980s, Japanese banks were able to intervene in the management of their troubled borrowers by sending their own staff to serve on the board. This is because land prices were on the rise; a situation that enabled creditor banks to forcefully recoup defaulted loans from distressed borrower companies by selling off collateral assets without incurring any significant loss. However, since the 1990s, when land prices plunged to a level far below the amount of outstanding loans, such threatening tactics have lost their effect. This is why Japan's main bank system as a governance mechanism has collapsed.

Prospects for future corporate governance

In the sections above, I outlined the current state of corporate governance, ranging from internal control and performance-based compensation to the roles of debt and capital market pressure. As mentioned, each of these governance mechanisms interacts with the others to collectively form a very complex mechanism. In the 1980s U.S., a wave of hostile takeovers occurred because internal control failed to properly function. Subsequent reinforcement of internal control, as seen in the increased number of independent, outside directors, and the enhancement of performance-based compensation resulted in the significant decline in hostile takeovers. Independent, outside directors appear to be playing a particularly important role.

The outside director system can be likened to a large trade association. It helps guarantee a certain level of quality by linking executive compensation and dismissal decisions to stock performance. At the same time, however, it has created a mechanism in which CEOs and other corporate executives, by using problems regarding stock options to their advantage, can build enormous wealth when stock prices go up, while losing little or nothing when they go down. When a willing acquirer emerges, stock options held by corporate executives turn into a golden parachute. And if the takeover succeeds, the executives are entitled to benefit from takeover premiums. There have been a series of new moves, in the U.S. for instance, to return decision-making authority regarding executive compensation to the shareholders and to limit executive compensation to a specific multiple of the average salary of employees. It is unclear whether these actions, even if realized, would result in a better and more effective system than what is already in place; general meetings of shareholders, as a governance mechanism, just do not work properly.

It should be emphasized that in the U.S. the corporate governance system provides a high degree of transparency and there is a significant accumulation of relevant theoretical and empirical research. In particular, the disclosure of individual executive pay provides the greatest insight into the role of outside directors. In Japan, transparency of corporate governance has been steadily increasing in recent years and the degree of transparency will ideally reach a level equal to the U.S. As pointed out in Guidelines Regarding Takeover Defense for the Purposes of Protection and Enhancement of Corporate Value and Shareholders' Common Interests, jointly issued by Japan's Ministry of Economy, Trade and Industry and Ministry of Justice, a high degree of transparency in corporate governance is essential also from the standpoint of ensuring an environment where internal control reform to strengthen the role of outside directors along with enhanced performance-based compensation can serve as an effective defense against hostile takeovers.

June 27, 2007

June 27, 2007

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