RIETI Report Oct 2005

Tackling Takeover Regulation and Corporate Governance Reform in Japan

Greetings from RIETI

Japanese companies in the past decade have had some success in appointing top-level foreign executives to revive them. In Japanese yakyuu (baseball), many foreign players brought in to provide some extra punch have excelled, yet foreign managers have not always fared so well. Not this year. Foreign figures past and present took center stage in this October's Japan Series as the Hanshin Tigers fell to the Chiba Lotte Marines. Hanshin fans had celebrated their 1985 Japan Series victory by having fans representing each Tiger jump into Osaka's Dotonbori Canal. Realizing there was no look-alike on hand for Randy Bass, Hanshin's legendary bearded American slugger, fans seized another bearded American icon, a storefront KFC (Kentucky Fried Chicken) Colonel Sanders statue, and tossed it into the canal. Mysteriously, the statue was never again seen, thus establishing the "Curse of the Colonel" -- a two-decade title drought. Ever-smiling Barentain kantoku -- former Major League (North American) World Series Manager Bobby Valentine -- led the Marines to the Series title with a Carlos Ghosn-like resurrection of a recently foundering team. Valentine is noted for his approachability and creative training techniques, yet also respected for his efforts to appreciate Japanese communication style and work ethic. So while the Colonel's curse will have to linger over Osaka another year, the fans in Chiba can celebrate their very effective foreign leader.

Adopting and incorporating a new managerial approach such as Valentine's may be the key to survival in sport's increasingly global climate. Many Japanese corporations are also looking abroad for alternate means of governance to integrate with their own styles. Changes in the macroeconomic environment, combined with rapid advances in deregulation and institutional reforms since the second half of the 1990s, are causing large-scale shifts in the governance structures of Japanese corporations. In light of these developments, on September 13 and 14, 2005, RIETI and the Center for Economic Policy Research (CEPR) hosted the RIETI-CEPR Conference to better understand the state of Japan's corporate governance system, to assess changes to this system, and to examine the future direction of reform based on a comparison with EU countries. To follow up the event, RIETI Report interviewed Faculty Fellow Peng Xu, one of the discussants at the conference, about the major findings and the implications for corporate governance reform in Japan.


For most of his career, Dr. Xu has taught at Hosei University's Department of Economics. He has also spent time at the University of North Carolina, Chapel Hill, and Ohio State University, both as Visiting Researcher and Professor. Since 2001, Dr. Xu has served as Professor of Faculty of Economics at Hosei University. His areas of expertise include corporate finance, corporate governance, and law and economics. His major works include "Increasing Bankruptcies and the Legal Reform in Japan," Journal of Restructuring Finance, Vol.1, No.2, 417-434, 2004; "Executive salaries as prizes of tournaments, and executive bonuses as managerial incentives in Japan," Journal of the Japanese and International Economies 11, pp.319-346, 1997. He holds a Ph.D. in economics from the University of Tokyo.


RIETI Report: What, in your view, were the major findings at the RIETI-CEPR Conference titled "Corporate Finance and Governance: Japan- Europe Comparisons"?

XU: Before I talk about the major findings, I will briefly explain the background of corporate governance. The basic debate started in the 1980s when businesspeople, economists and policymakers were looking to the German and Japanese styles of corporate governance, a bank-centered or stakeholder-oriented system. In the 1980s, the U.S. economy was stagnant while the German and Japanese economies were booming. Therefore, people tried to take policies from the German and Japanese styles of corporate governance in order to achieve strong economic growth. But over the next two decades, things totally changed. Businesspeople, academics and policymakers are now looking to U.S.-style corporate governance because the U.S. economy is growing faster than any other matured economy. However, U.S.-style corporate governance itself has changed a great deal over the last two decades. Before 1980, the corporate governance movement was not very active in the U.S. In the 1980s, there was a wave of hostile takeovers and leveraged buyouts, which was regarded as a capital market response to corporate governance deficiencies and consequently led to increased awareness of the importance of corporate governance. In the 1990s, shareholder activism caused many firms to adopt stock-based compensation.

The question is which would be the best corporate governance system. Actually, the answer is mixed. It depends on the environment and economic conditions. For growing economies, corporate governance basically does not matter. There are many styles of corporate governance, including U.S., European, and Asian styles, or market-based, bank-centered and state-oriented systems. These different styles work in various ways when the economy is booming. However, when the economy is declining or stagnant, a market-based system, an Anglo-American corporate governance style, is more desirable than a bank-centered or stakeholder-oriented system because it works more effectively in terms of transferring capital from declining industries to emerging ones. Restructuring and insolvency practice in Japan suggests that private equity funds do a better job in this area than a main bank or the government. The typical example is the Long-Term Credit Bank of Japan, now called Shinsei Bank, which was acquired by the U.S. private equity fund, Ripplewood Holdings. The fund not only successfully restructured Shinsei Bank but also acquired many insolvency firms in Japan. On the other hand, in German the economy has been in trouble for over a decade and the process of moving capital from declining industries to emerging ones has been quite slow. This implies that German-style corporate governance, a bank-centered system, does not work well for moving capital or forcing firms to exit.

I think the most important topic at the conference was M&A, particularly hostile takeovers in Japan. There were so many findings at the conference, but I picked up only one paper, "Corporate Governance Convergence: Evidence from Takeover Regulation Reforms in Europe," by Dr. Marc Goergen. According to his paper, overall, European takeover regulation has been harmonized with the UK regime. However, it is important to note that similar regulatory changes may have different effects within different systems. Therefore, despite some evidence of increasing convergence, it is not clear whether corporate governance regimes are in fact converging to a single system. Similarly, Japan has adopted many features of the U.S. style of corporate governance in the last decade. For instance, appointments of outside directors, granting stock options and repurchasing stocks now are quite popular. But 10 years ago none of these was common to the Japanese economy. Since 2000, there has been a rise in hostile takeovers and shareholder activism -- as a consequence, Murakami has become a household name -- that can be interpreted as attempts to move capital from matured and declining industries to emerging ones. In my opinion, however, it is more important to dynamically compare the evolution of two systems and investigate whether two systems follow the same path. As mentioned above, the U.S. style reinvented itself after the 1970s. In other words, in Japan we need to know which system is the most effective in moving capital from matured and declining industries to emerging ones.

RIETI Report: According to the paper presented by Dr. Renee Adams, board size does not negatively affect firm performance. This is quite in contrast to the institutional investors' argument that a smaller board is more desirable. What would be the implications for corporate governance reform in Japan?

XU: That was one of the most interesting papers. The empirical findings are usually mixed but the implication is that it can be counter-productive to introduce a "one size fits all" corporate governance structure. Fortunately, the current Japanese Corporate Law allows companies to choose to either adopt the U.S. style of board structure with outside directors and three committees (for audit, compensation and nomination) or continue a traditional statutory auditor system. It is good to give companies freedom to choose a corporate governance structure.

RIETI Report: In your writing you have stressed the importance of the disclosure of individual executives' compensation and the need to provide management with incentives in the form of performance-linked compensation. While many Japanese companies have adopted performance-linked compensation for executives in recent years, only a few companies have started to disclose individual executive compensation. How would you analyze this situation?

XU: In my opinion, it is a problem of transparency. Transparency constitutes an important element of U.S.-style corporate governance. It is complementary to independence of outside directors and stock option based executive compensation. Many Japanese companies are interested in granting stock options to executives and appointing outside directors, but have a strong resistance to disclosing executive compensation. I think this is a big problem. Actually, in the early 1980s, U.S. corporations were also reluctant to disclose executive compensation. Then the U.S. government adopted many policies including tax incentives for corporations to encourage disclosure of executive compensation. The only linkage between shareholders' interests and managers' interests is an executive compensation contract. Therefore, disclosure of executive compensation is very important to increase transparency in corporate governance. Japan should also provide incentives such as tax schemes for firms to encourage disclosure.

RIETI Report: The Japanese government issued takeover guidelines in May 2005 but they have no formal enforcement mechanism. How will these guidelines work to regulate takeovers in Japan? What else can be done to ensure the effects of the takeover regulation?

XU: First of all, we need to look back upon hostile takeovers which took place in the U.S. during the 1980s. I think the central question is whether hostile takeovers and M&A in general will create value or destroy value for the firms. When a hostile takeover is announced, there will be an equity premium. Where does such a premium come from? Some people argue that it is merely the transfer of wealth from stakeholders to shareholders. This opinion is quite common in Japan. However, in general, empirical findings suggest that hostile takeovers do not destroy firm value. The amount of wealth transfer from employees to shareholders is about 5% or less of the stock premium. The evaluation of hostile takeovers in the 1980s indicates that takeovers, in most cases, create firm value. Of course, there are some exceptional cases.

When it comes to Japan's case, the first step we need to take is to characterize the target firm. Let me talk a bit about the Murakami Fund and Steel Partners. In my opinion, their activities are the hybrid of hostile takeovers and shareholder activism. They take such a strategy because the interlocking shareholding ratio in Japan is as high as 40% and it is extremely difficult to acquire more than 50% stakes from the market. Actually, most target firms were not taken over but often restructured in response to the threat of hostile takeovers. The Murakami Fund usually buys 10% or 20% of shares to put pressures on managers, and recently acquired about 38% stakes in Hanshin's case. Now I will go back to the point: What companies will the Murakami Fund and Steel Partners target? The findings in my recent study indicate that the target firms have less investment opportunities but have ample free cash flow. This means that the possibility for the Murakami Fund and Steel Partners to destroy the firm value is very low. Moreover, hostility pressures often facilitate value creation via restructuring. Therefore, we should encourage friendly and hostile takeovers if such takeovers create firm value. We need to regulate takeovers if they would destroy value. Also we should protect minority shareholders if takeovers transfer wealth from stakeholders to particular shareholders. Indeed, Japan's takeover guidelines lack a formal enforcement mechanism, but the market will make the judgment. We should respect the market's judgment, and even the courts should respect it. In my opinion, hostile takeovers are the market reaction to who manages the firm.


The handouts for the RIETI-CEPR Conference "Corporate Finance and Governance: Japan-Europe Comparisons" are available at:

You can view the video of the above conference at:


Brown Bag Lunch Seminars

All BBLs run 12:15 - 13:45, unless otherwise stated.

TAKASHIMA Hatsuhisa, Special Assistant to the Minister for Foreign Affairs (MOFA)
Title: "Public Diplomacy in Japan" (in Japanese)

MOGI Yuzaburo, Chairman and CEO, Kikkoman Corporation
Title: "Corporate Governance in Japan: The Role of Independent Directors" (in Japanese)

NAKAGAMI Hidetoshi, President, Jyukankyo Research Institute Inc. and MURAKOSHI Chiharu, Director, Jyukankyo Research Institute Inc.
Title: "Recent Activities of ESCO Industry in Japan" (in Japanese)

SHIRAISHI Takashi, Faculty Fellow, RIETI / Vice President and Professor, National Graduate Institute for Policy Studies (GRIPS)
Title: "East Asia Community-Building and Japan-US Alliance" (in Japanese)

Dominique GUELLEC, Chief Economist, European Patent Office (EPO)
Title: "Patent Policy in the Knowledge-Based Economy: Trends and Issues in OECD Countries"

For a complete list of past and upcoming BBL Seminars, http://www.rieti.go.jp/en/events/bbl/index.html

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This month's featured article

Tackling Takeover Regulation and Corporate Governance Reform in Japan

XU PengFaculty Fellow, RIETI

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