Local and foreign observers have attributed the low "metabolism" of Japan's economy to the low productivity and comparatively low profitability of many Japanese companies. To address these problems, the Abe government has lent its political weight to corporate governance reforms.
Japanese investors will not become 'activists' in the American sense, but more engagement should be expected.
First, it introduced a Stewardship Code in 2014 for institutional investors and fund managers. Then it amended the Companies Act requiring at least one outside director and a Corporate Governance Code for listed companies. Skeptics wonder if these reforms are truly meant to improve ethics and corporate performance and not merely to pressure companies to spend their large pile of cash on capital investment or higher dividends to boost the economy. This is not the case, according to Arthur Mitchell, a senior counselor with White & Case in Tokyo. "While much will depend on how these changes are implemented in the next few years, it is clear they contain the tools to enable market participants to change corporate performance," he says. "As such, these reforms represent one of the most significant achievements of Abenomics to date, one that could transform Japan's corporate culture." The major policy shift was outlined in the Japan Revival Vision published by the ruling Liberal Democratic Party (LDP) in May 2014. The key aspects of the initiative were:
- encouragement of deeper stockholder engagement and dialogue with
- corporate management
- promotion of more outside and independent directors
- allowing for disposal of cross-shareholdings by corporations and
- "policy stockholdings" by banks
- repositioning the investment
- strategy of the Government Pension Investment Fund
- placing a new emphasis on transparent reporting of results
These policies are being implemented as both "soft" and "hard" law. The Stewardship Code, a form of "soft law," requires institutional investors to comply with a set of seven principles of transparency and accountability or to explain why they cannot.
Political backing from the Abe government and key business opinion leaders helped reformers amend the Companies Act.
Arthur Mitchell, Senior Counselor, White & Case, Tokyo
To date, the vast majority of institutional investors and fund managers have indicated that they will comply with the principles. The Japanese Code is closely modeled on the UK Stewardship Code, which emphasizes "escalating" engagement with management. Complying parties need to explain how they are engaging in dialogue with their investee companies on a wide range of corporate issues such as governance, strategy, risk management, performance and capital structure.
While it is impossible for investors with hundreds of companies in their portfolios to have an effective dialogue with the management of each company they put their money into, code-compliant fund managers must develop policies that demonstrate how they are engaging with investors and disclose this on their websites every year. As fund managers redeploy and hire new staff, to take up these new responsibilities, more focus will be placed on companies in which they hold large equity positions. Traditionally, directors of big Japanese companies have been promoted from within the ranks of senior management, leading to situations where important questions of corporate strategy risk, promotions and compensation are not examined by the board in any detail. Many in the business community opposed mandatory appointments on the view that outsiders who lack detailed knowledge of operations cannot make appropriate business decisions. But others believe outside directors who are not beholden to constituencies within the company are in a better position to explore the rationale for business decisions and alert management to new risks and opportunities.
"Political backing from the Abe government and from key business opinion leaders helped reformers amend the Companies Act in 2015 to require reporting companies to appoint at least one outside director or to explain why that is not possible," says Mitchell.
The Japan Exchange Group (the successor to the Tokyo Stock Exchange) also amended its listing requirements by creating a Corporate Governance Code, which calls on listed companies to appoint at least two independent outside directors or to explain why they cannot. Mitchell adds: "This is still a far cry from New York Stock Exchange rules, which require a majority of outside directors, but the review of the Companies Act amendment in the next year or so will provide an opportunity to consider whether mandatory rules are needed."
of listed companies in Japan had at least one outside director at the end of the 2015 annual meeting season and more than half had at least two—a trend that looks set to continue under the Companies Act.
Despite their diminished role as monitors of corporate performance, Japanese banks have been charged with setting new standards for corporate governance. During the recent decades of low growth brought on by the bursting of Japan's economic bubble, the big banks consolidated into three mega banks, each of which has been reorganized under a holding company structure. Last year, independent outside directors were elected to serve on each of the holding companies and bank subsidiary boards.
In each case outsiders now represent more than a third of the board positions for the holding companies and, in one case, slightly less than half. New committees composed of both inside and outside directors will consider audit, risk, personnel and compensation issues.
The so-called policy stockholdings of the banking groups have declined in recent years but still amount to approximately ¥14 trillion (US$116 billion). Crossholdings of corporations are also in decline. Previously, it was thought the close business relationships fostered by these holdings outweighed concerns about conflicts of interest or lack of economic incentives. In order to place more emphasis on corporate performance, the banks are now reconsidering their criteria for holding or disposing of these shares. The Corporate Governance Code requires companies to formulate similar polices and disclose these as well as the economic rationale behind any crossholdings. Measures to avoid potential disruptions of the market related to the sale of these positions will be needed. But this new policy will foster the redeployment of the proceeds to companies that provide higher returns on equity and assets.
The LDP's "Revival Vision" called for significant reforms in the way the Government Pension Investment Fund (GPIF) is managed and charged it with setting an example in asset management and risk control for other institutions. The GPIF responded by announcing it would shift its focus away from government bonds and toward higher yielding equities and alternative investments by taking a large position in the JPX-Nikkei Index 400.
Critics charge this is merely a cheap way to lift stocks by a government affiliated entity, but in reality it represents a sea change in the way pension funds make allocations.
In March 2015, three other public employee pension funds announced they would follow GPIFs "model portfolio" weightings of 35 percent Japanese bonds, 25 percent apiece for domestic and international equities, and 15 percent for foreign bonds.
By making these changes, the GPIF hopes to demonstrate that disciplined risk-taking is far better for its pensioners and the country than parking assets in low yielding assets.
People who call these government reforms shortsighted are being shortsighted themselves, argues Mitchell. "While focusing on the immediate outcomes of the new measures they fail to recognize the broader government strategy of providing role models to introduce new standards of corporate governance," he says.
This form of precedent setting is precisely the type of mechanism that can lead to real change in Japan's corporate culture, he suggests.
Influential Japanese politicians and bureaucrats now recognize the role of government is to foster an environment that will allow the private sector to flourish while protecting the public interest. The recent governance reforms that apply to fund managers and large corporations do not mandate or guarantee specific outcomes. "Henceforth the primary responsibility for monitoring corporate performance is likely to shift from the main banks to investors," says Mitchell.
To create a virtuous circle where better corporate performance leads to more employment and higher incomes, it is up to corporate management and their directors, fund managers and the banks to employ the new tools in an effective manner.
Mitchell concludes that Japanese investors will not become "activists" in the American sense, but more engagement should be expected.
He says: "It is not likely that future corporate scandals and bankruptcies will be completely eliminated, but the new checks and balances make it more likely that conflicts of interest will be reduced and that management will focus on profitable growth opportunities for their businesses."
An evolutionary model for Japan
The corporate governance changes being implemented in Japan are evolutionary, not revolutionary, which suits the country well. Anything mandatory would not have worked.
That is the view of Arthur Mitchell, a senior counselor with White & Case in Tokyo. But that doesn't mean everyone was on board from the start, he says.
"There was some opposition to corporate governance reform from Keidanren (the Japan Business Federation) and others early on," he recalls. "Opponents lobbied successfully to dilute some of the proposed changes—for example, not to go as far as having majority outside directors." The Company Law amendment says that it is advisable to have at least one outside director (or explain why not), while the Corporate Governance Code says you should have at least two (or explain why not). The Financial Services Agency, meanwhile, encouraged leading banks to have more than one-third outside directors, something that the megabanks and their holding companies have now achieved. This tug-of-war over how many is too many (or too few) isn't likely to be resolved anytime soon, says Mitchell.
On the other hand, some critics believe that the reforms do not go far enough or fast enough. As an observer of Japan for almost 50 years, Mitchell believes these reforms provide the tools that will allow corporate performance to be improved in the long run. "The tools are on the table and it's up to everybody—fund managers, investment advisors, banks—to interact in the right way," he says. "The appointment of independent outside directors alone is not enough." Much, he says, will depend on how the staff and management engage with outside directors, institutional investors and fund managers. "If they don't, it will all be for nought." It's a lot to swallow but Mitchell remains optimistic.
This publication is provided for your convenience and does not constitute legal advice. This publication is protected by copyright.
© 2016 White & Case LLP