Corporate governance represents the relationship among various corporate stakeholders that determines the strategic direction of a company. Practically, corporate governance adjudicates the balance among key stakeholder interests within the firm. Japan is unveiling a new corporate governance code for companies, in addition to the recently released ‘stewardship’ code for institutional investors, as it seeks to recover from decades of low economic growth. This effort to bring transparency and accountability to corporate structures will provide an interesting case study in understanding how governance issues affect financial performance of companies and their valuations.
Corporate governance in Japan has undergone significant changes since the post-war structure where firms managed their own affairs, supervised by boards usually composed of insiders promoted from the managerial ranks. The only outsiders allowed were statutory auditors (Kansayaku) who provided information to stakeholders, including financiers and shareholders. Following the economic boom in the 1980-90s, a number of corporate governance reforms were undertaken including liberalized stock option plans, changes to merger law, limits placed on director liability, and reformed bankruptcy laws. Finally, in 2002, a set of reforms enabled Japanese companies to enact Anglo-American style governance structures that emphasize external accountability, including committees comprised of independent directors. Further reforms were undertaken in 2005 to improve the Kansayaku system.
However, Japanese companies have not embraced all elements of corporate governance even in the face of increasing global ownership and competition. By 2012, only 2.2% of the TSE-listed companies had adopted an Anglo-American style structure and 45.3% of companies listed on the Tokyo Stock Exchange (TSE) lacked any independent directors. Boards of companies listed on the TSE had an average size of eight directors, but an average of only one independent director.
In March 2015, the Financial Services Agency of the Japanese Government released a final proposal of “Japan’s Corporate Governance Code” to be rolled out in mid-2015. The Code defines corporate governance as a ‘structure for transparent, fair, timely and decisive decision-making by companies, with due attention to the needs and perspectives of shareholders as well as customers, employees and local communities.’
A New Code of Conduct
The Code establishes fundamental principles for effective corporate governance that account for Japanese company structures. The companies in Japan may choose one of the following three forms of corporate organization:
- Company with Kansayaku Board (most companies currently use this structure)
- Company with Three Committees – nomination, audit and remuneration
- Company with Supervisory Committee
The traditional Kansayaku board structure with a statutory auditor is the least comparable to the Anglo-American corporate governance model as all directors are typically managerial staff and these directors nominate the statutory auditor. The ‘company with three committees’ is a shareholder-oriented alternative to the Kansayaku system based on a governance model from Sony. This model includes three committees that are common in the Anglo-American model, and the committee’s decisions cannot be overruled by management. The supervisory committee, introduced in 2005, is a modified version of the Kansayaku structure which adopts a committee of independent auditors.
The principles directly reference the OECD Principles of Corporate Governance and center on five areas:
- treatment of shareholders
- cooperation with stakeholders
- information disclosure and transparency
- board responsibilities; and
- dialogue with shareholders
The majority of the principles focus on core corporate governance action such as appropriate setting of business strategies and disclosure on a range of topics including cross-holdings, director conflicts, and capital expenditure programs. Employee principles seek to increase whistleblower protection and diversity, including the active encouragement of women within a company’s ranks. A number of principles focus on the increased hiring and use of independent board members.
The implementation of the code is based on a “comply-or-explain” approach; companies either institute the principle or explain why they won’t, with the expectation that that failure to adequately explain non-compliance will result in divestment by investors. In addition to the Code, the Japanese Parliament enacted a new law that effectively requires companies to install at least one independent director; this law comes into force in May 2015.
The Code also complements the Japanese Stewardship Code, released in April 2014, which outlines principles for institutional investors in fulfilling their responsibilities with due regard to clients, beneficiaries and investee companies.
In parallel, the TSE developed a new index called the JPX-Nikkei 400 in 2014, which includes companies that have historically generated higher returns on equity compared to the rest of the market and have integrated improved governance structures, including the appointment of at least two independent directors. The total historical returns to date are 26.4% for firms in the index, while the Nikkei (including these firms) had returns of 25.6% over the same period.
It remains to be seen whether companies will adopt the Code, or even parts of it, on the road to greater transparency. For investors, the introduction of the Japan Corporate Governance Code provides ideal conditions for measuring, in real time, the impact of improved corporate governance impacts on earnings and valuation.Sebastian Vanderzeil is a Research Intern at Cornerstone Capital Group and a Dean’s Scholar at NYU’s Stern School of Business currently completing an MBA. Previously, Sebastian worked as an economic consultant with global technical services group, AECOM, where he advised on the development and finance of major infrastructure across Asia and Australia.