Japan recently held an election that was essentially a confirmation referendum on ‘Abenomics’ – a growth policy for which corporate governance reform is the poster child of the most important policy theme, ‘structural reform’. Especially in the absence of labour market reform, it alone can lead to a significant increase in productivity and growth.
Unfortunately – unbeknown to the man on the street – specialists sense that Japan’s governance reform train is in danger of losing its momentum, when much still remains to be done.
To some extent this was inevitable. Most politicians don’t understand the deeper issues and what to propose next. Bureaucrats are always happy to declare victory, so they can get promoted to new positions. Despite all the hoopla over Japan’s Stewardship Code, most Japanese domestic institutional investors still have not acquired the courage to voice concrete, specific opinions in the policy arena. Talk about ‘constructive engagement’ and more proactive proxy voting makes most investors in any country worry about ‘more costs… and less profit’. So, they hold back all the more.
In the absence of more (and more detailed) pressure from investors, most executives only make the superficial changes in governance practices that will least disturb their organisation and the stability of their careers, regardless of the impact on long-term profitability, growth and even sustainability. Judged by their actions, many of them are hypocrites, who talk about long-term thinking, but ‘kick the can down the road’ as they wait to retire and move on to cushy jobs as ‘advisors’ that carry no legal liability. As with policymakers, it is just so much easier to do little and move on.
While significant progress has been made, Japan’s corporate governance problem, and the low productivity that comes with it, is not going to be optimally solved tomorrow at many firms. Quite simply, there is still a lot to fix here. Conversely, that means that the potential benefits are huge, but it will take time for them to be realised in full and more significant progress will require specific demands from investors. But if those benefits do not become more visible in the next few years, foreign investors will surely move on… by moving out. This would not bode well for the future of Japan’s economy, which needs their continued market participation and voice.
If you sit on a board, talk with investors and extrapolate the government’s own policy logic, the most important ‘next reforms’ that the government should take are not all that mysterious. They are:
1. Use the Company Law amendment process, now under way, to prescribe fiduciary duties for the many shikkou yakuinn ‘executive officers’ who do not sit as elected directors but manage the company at a senior level alongside executive directors and are often later ‘promoted’ to director status.
“UNFORTUNATELY — UNBEKNOWN TO THE MAN ON THE STREET — SPECIALISTS SENSE THAT JAPAN’S GOVERNANCE REFORM TRAIN IS IN DANGER OF LOSING ITS MOMENTUM, WHEN MUCH STILL REMAINS TO BE DONE”
There is clear precedent to do this, as executive officers in one form of corporate governance in Japan, the ‘three-committee-style company’ already bear the same fiduciary duties as directors per the company law and can be sued by shareholders for violating their duty of due care. However, unsurprisingly, only about three per cent of Japanese listed companies use the ‘three-committee-style company’ governance format, which is voluntary. At the other 97 per cent of listed companies, most so-called ‘executive officers’ are nothing other than employees under the labour law, who have to obey orders (or nonverbal ‘expectations’) from their ‘seniors’ on the board and cannot be sued by shareholders for malfeasance. ‘Shikkou yakuin’ is just a title; it is a phrase that does not appear anywhere in the company law.[1] The result is that when such persons are later appointed to the board, they not only have no prior board experience (and usually, no governance training), but they also have no prior familiarity with the concept of fiduciary duty owed to the company and shareholders. To quote from a recent article by a compliance expert writing recently in the Nikkei Newspaper: “Japanese companies are based on the practice of hiring all of their employees out of university and employing them for the long term… In the process, directors are promoted and advance in a ‘community’ and come to feel that they are the ‘selected few’ in that community… Senior executives have advanced for so long as ‘employees’ that it is difficult for them to be aware that they have fiduciary contracts with the company based on the company law and that they are subject to its rules.”[2]
Obviously, directors need to be made aware of such rules prior to their appointment as directors, not ‘after, if at all’. For this reason, I have suggested the codification of fiduciary duty for executive officers for years. And in fact, last April the Ministry of Economy, Trade and Industry (MET) proposed the exact same thing in a memo submitted to the Company Law Advisory Council, but it appears to have been completely ignored by the other members of the Council. Japan’s political leaders should not let METI’s good work go to waste in the final stages of the amendment process.
2. Similarly, use the company law amendment process to harmonise key aspects of the confusing array of three different corporate governance models that listed companies can adopt. By doing this, the Ministry of Justice could move Japan towards a more consistent version of the monitoring model for governance that has become internationally accepted, is now frequently mentioned here, and is reflected in Japan’s own corporate governance code. A more consistent version of monitoring, reflected in the law, would have a beneficial impact on the mindsets actions of both executive and non-executive directors.
3. Consistent with the monitoring model, revise the Corporate Governance Code next year (as is now scheduled) so that the criteria for claiming full compliance with the code requires a majority of independent directors on a company’s board and if there is not compliance, an explanation of the company’s reasons for not appointing them. Research shows that in most countries of the world, including Japan, companies with a majority of independent directors tend to out-perform those without them, especially when the shareholder base is fragmented and there are no large holders who drive governance.[3]
4. Adopt policies that will strongly encourage companies to further reduce unnecessary cross-shareholdings, which are usually just a not-so-subtle way of buying approval votes at the AGM from stable shareholders – something that technically is a punishable crime under the company law and wastes valuable capital or puts it at risk. A combination of tax incentives and enhanced disclosure would work nicely. Unsurprisingly, an increasing body of research shows that the level of such ‘policy holdings’ correlates with slower restructuring, less entrepreneurial investment and lower financial performance by Japanese companies, rather than raising profitability, as is often claimed.[4]
5. Set forth clearer guidance regarding the allowable topics and exact procedures that will provide institutions with bright-line sanctuary when they seek to coordinate their views and ‘collaboratively engage’ with Japanese companies. The Financial Services Agency (FSA) should work with institutional investors and respected law firms to bring this about, as was done in the UK by The Investor Forum when it fashioned its Collective Engagement Framework last year. As things stand now, investors fear that they may be reprimanded for not filing – or not updating – a bothersome large holders’ report (as a group) every time they attempt to communicate with a company in their portfolio. Given Japan’s continuing cross-shareholder problem as described above, this is an increasingly obvious issue that needs addressing.
6. Create strong incentives for corporate pension funds to sign the Stewardship Code, for example via disclosure to their employees and pensioners regarding their stewardship policies. Although hundreds of institutions (mainly fund managers) have signed the voluntary stewardship code, the signatory list includes only two non-financial corporate pensions. As huge asset owners, pensions are the biggest customers of fund managers and as such are best-positioned to influence their analysis, engagement and proxy voting practices by switching funds to the managers who are most dedicated. Oddly, Japanese companies pride themselves on how much they value employees, yet neglect employees’ pension assets by failing to sign the stewardship code and report how they have handled those funds. Why? Japanese companies are afraid that if their pension funds become more proactive, those same governance and proxy voting practices might boomerang on them at their own shareholders meeting.
Recently, a study group set up by the Ministry of Health, Labor and Welfare (MHLW) and the Pension Fund Association for the express purpose of encouraging corporate pension funds to sign the stewardship code, issued its report. As a result, it is rumoured that the huge pension funds of two iconic companies, Toyota and Panasonic, are now considering signing the stewardship code. (And as of this writing, it appears that Panasonic’s pension fund will sign.) If such firms sign, others will follow, because it would be embarrassing in front of employees not to sign. A little push from the government, via required disclosure, would be very easy to put in place and likely to be highly effective.
7. Enable more convenient ESG analysis by investors by improving disclosure data formats and databases so that data can be used free of copyright concerns and in machine-readable form, and can be easily analysed using artificial intelligence and text-mining methods. Japan has an open data national policy that professes to do this for all public data, but it seems that so far corporate disclosure has not been considered public data for purposes of this policy, even though it is in the public domain, is intended for unhindered public consumption and is provided to and by government agencies (such as the FSA) or stock exchanges that they regulate.
Thus, the result of the corporate governance code that I initially proposed for Japan has been that (as I intended) there is now much more disclosure about governance practices at each company to analyse, but: a) data providers are afraid of infringing copyrights held by corporations if they provide the full text of reports in a database; and b) sadly, not enough of the new data is being analysed and compared. Moreover, the TSE is not policing the quality and formatting of disclosure. As one simple example, TSE has, by its own hand, taken 11 completely separate disclosure categories in its corporate governance reports and lumped them under a single XBRL identifying tag: ‘disclosure items’. This makes it impossible for a computer to automatically find and separate the 11 disclosure items into the categories to which they pertain – for example, compensation policy, nominations policy, director training policy and the like. It would be a simple matter for the FSA, as regulator of the TSE, to order the latter to correct this mistake, which makes a mockery of the use of XBRL.
At this point, without strong, steadfast political guidance emanating from the Prime Minister’s office and the LDP, these policies are unlikely to be put in place. If they are not, the biggest contributor to productivity enhancement will fail to achieve its potential.
Because the LDP won the November elections by a wide margin, one of the following will occur: 1) either the Prime Minister, the LDP and government officials will be even more tempted to declare victory and will become preoccupied with amending the constitution; or 2) they will view their election victory as the clearest possible mandate to double-down and maintain momentum on corporate governance reform. Let’s hope it will be the latter that history records.
Footnotes
1. Amazingly, given that a literal translation of the word would be “executive board member”, which fact makes the title rather misleading and even raises legal concerns about “apparent authority”.
2. The Cause of Scandals is the Influence of a Sense of Unity, by Juichi Watanabe writing in the Nikkei Newspaper, Dec 22, 2017.
3. See Corporate Governance Codes on Board Composition and Firm Value, by Michele Catano, Naoshi Ikeda, 2016.
4. See Enjoying the Quiet Life: Corporate Decision-Making by Entrenched Managers, by Naoshi Ikeda, Kotaro Inoue, and Sho Watanabe (NBER Working Paper No. 23804, Sept 2017).
