The Evolution ofCorporate Governance in Japan:

The Continuing Relevance of Berle and Means

Takaya Seki, PhDMeiji University

Professor Thomas ClarkeUTS Sydney

Popular perceptions

Few outside directors

Board independence in question

Persisting corporate fraud and

scandals

Insufficient corporate disclosures

Cross-shareholding structure

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On the contrary

Duties of directors severely tested leading to appointment of outside, independent members

Substantially low level of remuneration

Structure of share ownership fast changing

Well-designed and versatile disclosures on corporate governance using XBRL taxonomy

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Future of Corporate Governance

Future of Directors

Future of Share ownership

Future of Investors

Future of Shareholder=Company Relations

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Board Structure Dominated by inside/executive directors

Number of outside directors on increase though slowly

Kansayakus, non-voting board members are more outspoken and visual

Much of the roles of audit committees are performed by Audit and Supervisory Board Members (Kansayakus)

Stock Exchange mandates at least one independent board member (either from board of directors or audit and supervisory board)

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Number of outside directors

headcountAll listed

companies (ca 3,500 companies)

Top 200+ companies by capitalization

Directors 7.4 11.4of whom outside 0.9 1.8

Audit & Supervisory Board Members* 3.5 4.4

of whom outside 2.3 2.6

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All TSE listed

companiesaverage number of dokuritsu-yakuin** headcount 2.2

*new translation of Kansayaku as recommended by JASBA (Nihon Kansayaku-Kyokai)

**independent outside members from directors or kansayaku as defined by the Tokyo Stock Exchange

Background of outside directors

Directors/Kansayakus

From other company 62.6%

Attorney-at-law 16.1%

CPA /Tax Accountant 13.6%

Academic and others 7.7%

Of whom from major shareholders 19.2%

Of whom from banks 11.1%

Of whom from government bureaus 1.9%

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From TSE Corporate Governance White Paper 2013

Concepts of company law Underlying ideas of Company Law in Japan are

very similar to other major economies

Corporate personality in place (separation/independence of company asset)

Shareholders own securitized asset of company (shares) and have residual claim

Directors appointed by shareholders to look after company’s asset, to serve the best interest of the company

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Duties of directors Duty of care Duty to avoid conflict of interests Duty of loyalty

Severely tested recently at Responsibilities over financial statements and

internal control Hostile bid and takeover defense measure Corporate scandals and fraud Litigations from shareholders

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Promotion of independent directors

By Rulemakers Company Law Review Committee recommends

nomination of outside directors Stock Exchange requires appointment of at least

one independent director/kansayaku

By Institutional Shareholders Pension Fund Association encourages investee to

appoint outside directors ISS recommends negative votes for companies

without outside directors

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Level of Executive Remunerations

Annual compensation in million yen

All listed companies (ca

3,500 companies)

Top 200+ companies by capitalization

Directors 21.4 38.5

of whom outside 3.5 7.6Audit & Supervisory Board Members* 9.1 20.6

of whom outside 2.3 2.6

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Amount in million yen: divide by 100 to obtain Aus/US$ equivalent

Executive remunerations

Average payment modest compared with overseas competitors

Highest paid are found among executives selected internally but their level not subject to market competition

Individual disclosure required under limited cases, government intervention is minimal

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Share ownership compared

2010 (%) Japan US UK Germany France

Government, Local Government 6.2 2.9 2.3 8.7

Banks 9.0 18.0 3.8 19.0

Insurance and Trusts 14.9 47.8 21.9 19.8 1.1Non-financial Corporations 22.9 2.2 41.0 21.1

Overseas 26.7 12.7 40.0 22.0 38.7

Individuals 20.3 39.5 15.0 11.0 11.5

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Flow of Funds from each central bank (UK: Office of Statistics)

Share ownership in Japan

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Source: Tokyo Stock Exchange 2012

(%)Governmen

tBanks

Insurance, Pensions

and Trusts

Non-Financial

Corporations

Overseas Individuals Total

1950 3.1 12.6 11.9 11.0 0.0 61.3 100.0

1960 0.2 30.6 3.7 17.8 1.3 46.3 100.0

1970 0.6 13.7 19.2 23.9 4.9 37.7 100.0

1980 0.4 17.5 22.2 26.2 5.8 27.9 100.0

1990 0.3 20.9 23.8 30.1 4.7 20.4 100.0

2000 0.2 19.2 20.6 21.8 18.8 19.4 100.0

2010 0.3 14.7 16.8 21.2 26.7 20.3 100.0

Types of Keiretsu shareholdings

Horizontal Keiretsu shareholding Mitsubishi, Sumitomo-Mitsui, Mizuho

Vertical Keiretsu shareholding Automobiles, Large machineries, Retails

Shareholding for maintaining relationship Vaguely defined as shareholding not be sold for

profit taking or dividend

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Institutions Investing in Japan Domestic

Pension/Assurance Investment companies Banks Business corporations

Overseas US and European Pensions/Investment

companies Short-term investors SWF and investments from new economies

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Shareholding structure in Asia State-ownership is prevalent in Asian economies. A number of

them have established entities to oversee state-owned enterprises (SOEs) (for example, Temasek Holdings in Singapore, Khazanah Nasional in Malaysia, and the State-owned Assets Supervision and Administration Commission of the State Council in China).

Indeed, state-ownership is perhaps one of the defining traits of the economic landscape of China, where the state held approximately 83.1% of market capitalisation in 2007.

However, in many markets individuals and their families are dominant shareholders (for example, in Hong Kong, China). These individuals or families may control a large group of companies, with relatives and their advisers typically sitting as directors on group company boards.

OECD (2011), Reform Priorities in Asia:Taking Corporate Governance to a Higher Level,

Asian Roundtable on Corporate Governancewww.oecd.org/daf/corporateaffairs/roundtables/asia

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Voting results at AGM Ratio of votes cast in favor of management

policy

*From Annual Securities Reports**Analysis by Sumitomo-Mitsui Trust Bank

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(%) Votes by all shareholders*

Votes by institutional shareholders**

All agendas 95.4 81.2

Election of directors 95.4 76.4

Election of kansayakus 94.7 77.2

Remuneration packages 94.8 74.4

Approving Takeover defense measure

81.7 25.0

Shareholder Proposals 22.6 7.7

What voting records indicate Institutions more critical on corporate

governance issues Dissident private shareholders study

voting styles of institutions to leverage their argument

 To avoid unnecessary discords: Companies need to agree on ‘code of best

practice’ with institutional investors so that investors can concentrate on nonrecurring matters

Institutions also must be aware of their own accountabilities to ultimate owners

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Changing share ownership Impact of changing share ownership

Ownership by banks and business corporation are on decrease

Domestic Pensions/Assurance will maintain level of ownership but may remain inactive

Investment companies with domestic/overseas clients will be more active in corporate governance

Company directors find it increasingly difficult to establish relationship with short-term investors

‘Stewardship Code’ in Japan? Companies feel impact of changing voting practice Institutions need to be aware of their duties to true

owners

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Chain of Fiduciary in Japan

1. Employees be answerable to Managers

2. Managers be answerable to Executives

3. Executives be answerable to Directors

4. Directors be answerable to Shareholders

5. Shareholders be answerable to

Employees

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Drive to accelerate changes Influence from Overseas

New initiatives on corporate governance International institutional investors

Lessons from accounting frauds and wrongdoing Kanebo, Seibu, Olympus Classic corporate crimes such as payments to racketeers

or corruption are decreasing

From participation by general public As ultimate owners of companies As taxpayers

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New initiatives Company Law Review

Further measures to encourage companies to appoint at least one outside director*

*Companies without outside directors will be required to state reasons justifying for not having any outside directors

Introduction of audit and supervisory committee to oversee executive function

Board Independence and Diversity By self-regulation through SE listings

Institutional Stewardship

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APPENDIX

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Corporate Governance in Japan

Shareholders Meeting

Kansayaku-kai (Audit and

Supervisory Board)

Board of Directors (Torishimariyaku-

kai)

Independent Auditor

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Two formats of board structure

Companies with Kansayaku Board of Directors (Torishimariyaku-kai) Audit and Supervisory Board (Kansayaku-kai)

Companies with Iinkai Board of Directors with three statutory

committees (audit, nomination and remuneration) Statutory Executive Officers including Chief

Executive to be appointed by Board

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CG in Japan, Participants Listed Companies (3,600)

Shareholders (some cross-shareholding, institutional investors, individuals, overseas)

Governments, etc. (FSA, METI, MOJ, TSE)

Independent Auditor (Four major audit firms)

Others influencing policies (business organizations, universities, professional firms)

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Regulations over CG Company Law

Company Law on Corporate Governance Civil Law on duties of directors

Securities Regulation Transparency and accountability Responsibilities on Financial Statements Prohibiting insider trading/malpractices

Stock Exchange regulations Independence of board members Parent-subsidiary listing

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The Continuing Relevance of Berle and Means

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The Emergence of the Modern Corporation

The modern corporation that emerged in the early part of last century was typified by Berle and Means as manifesting a separation of ownership and control, where professional managers were in a position to determine the direction of the enterprise and shareholders had “surrendered a set of definite rights for a set of indefinite expectations”(Berle and Means 1933:244)

After the New Deal and the end of the second world war many US corporations in the 1950s and 1960s increased massively in scale and market domination, achieving pre-eminent positions in world markets.

 

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Technocratic Managerialism A new managerial and corporate mode of coordination of

enterprise based on organization and planning had arrived as analysed by Coase (1937) and later Chandler (1977), transcending the market. This was an era celebrated in Galbraith’s New Industrial State (1967) in which corporate growth and brand prestige apparently had displaced profit maximisation as the ultimate goals of technocratic managers, as planning and administration in close cooperation with government had displaced market relations as the primary corporate dynamic (Henwood 1988:259).

In this technocratic milieu shareholders were “passive and functionless, remarkable only in his capacity to share without effort or even without appreciable risk, the gains from growth by which the technostructure measures its success”(Galbraith 1967:356).

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The End of an Idyll and Rise of Financialisation

The Galbraithian idyll began to disintegrate with the severe recession of 1973/75, the incapacity of US corporations to compete effectively with Japanese and European products in key consumer market sectors, and the push towards conglomerate formation by Wall St which was interested in managing multiple businesses by financial performance.

Subsequently, in successive waves, US corporations were subjected to further financial imperatives “Over time purely financial interests have increasingly asserted their influence over hybridized giant corporations” (Henwood 1998:262).

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Agency Theory and Shareholder Value A fertile scene was set for Michael Jensen, his colleagues in the

Business and Law Schools at Harvard, and the Chicago school of economics, to develop a finance-based theory of corporate governance that was to envelop Anglo-American policy and practice. While agency theory and shareholder value were the most enduring principles of the Jensen legacy, they were preceded and accompanied by other financial innovations including leveraged buy-outs (LBOs), junk bonds and “disgorging” free cash flow (Lazonick 1992).

For Jensen “the stock market is always axiomatically the ultimate arbiter of social good” (Henwood 1998:269).

However the result of eliminating the free cash flow of companies in leveraged buy-outs, and in loading up companies with debt, was to leave US companies without capital to invest in research and development at a time of increasing competition from overseas companies engaged in continuous product development (Blair 1993)

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Corporations and Shareholders

Such financial innovation amounted to Jensen to “the eclipse of the public corporation” (Harvard Business Review 1989)

This article received a robust response. Peter Róna, head of Schroder Bank in New York, maintained that by exclusively privileging shareholder interests Jensen pre-empted “thoughtful analysis of the very question that is at the heart of the issue – what should be the rights and privileges of shareholders?” Róna questioned Jensen’s assumption that shareholders are better judges of capital projects than managers and corporate boards as “an ideologically inspired assertion that lacks empirical support” (1989).

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A Tale of Two Systems The increasingly aggressive market for corporate control in

the 1970s and 1980s was not primarily efficiency-enhancing as Jensen maintained, and there is little support for the “inefficient management displacement hypothesis” (Ravenscraft and Scherer 1989).

Meanwhile with a keen focus on product development, high quality, and growth in market share for the long term Japanese corporations turbo-charged their way to market dominance in major sectors of the Western economies in the 1970s and 1980s. The Japanese economic miracle inspired (and invested in) the rapid economic development of the East Asian economies

The bursting of the Japanese bubble in the early 1990s coincided with the revival of the US economy around software industries in the 1990s, and finance in the 2000s

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Japan’s GDP Growth 1961 to 1999

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Japan’s GDP Per Capita Relative to US 1961-1999 (ppp)

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The Financialisation of Japanese Corporations?

Japanese economic institutions were well suited to both post war reconstruction and “catching up” with other advanced economies, but not to surpassing them. Japan’s “catch up” was essentially complete by the late 1980s. The business-government cooperation and bank-centered corporate governance that served Japan well for decades are now ill-suited in critical ways to guiding Japan further forward. Yet these institutions continue with an inertia that reduces Japan’s ability to find and invest in new economic opportunities, including new enterprises.

If equity markets to play a fuller role requires dismantling of inter-corporate equity holdings, more transparent corporate decision-making, and corporate governance that is more responsive to shareholder pressure. (Morck and Yeung)

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The Ongoing Governance Debate in Japan

A tension between the company as community, and the company as property (Buchanan, Chai, and Deakin 2012)

On one side ‘traditional’ Japanese corporate governance, characterised by features such as the power of internally promoted management to run large, listed companies with minimal external supervision, concern with the company as a continuing community, and a lack of direct attention to shareholder interests (Buchanan and Deakin 2007: p.1).

On the other side the view that in order to restore the national economy to good health, Japanese business needed to adhere to an emerging global consensus in corporate governance (Ahmadjian, 2003, p.222).

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Activist Hedge Funds and Corporations The growing contrast between the US emphasis on

shareholder value and the Japanese indifference to shareholder rights was widely remarked on, but had few practical effects because the two systems had few opportunities to impact on one another.

All of this changed with the emergence of hedge fund activism in Japan. American activist hedge funds were often confrontational investors who targeted companies which they believed were squandering shareholder value.

As this strategy was successful in generating above-market rates of return for the funds and their own investors, they turned to other markets, in Europe and in Japan. In Japan, the approach of the funds came into immediate conflict with the idea and practice of the community firm which still retained widespread support (Buchanan, Chai, and Deakin 2012:5)

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Whose interests should a company serve?

Is it the property of shareholders, for them to do whatever they want with it, or does it have a wider social purpose?

Geoffrey Owen (Financial Times 27 June 2012)

The enduring relevance of the key questions of Berle and Means:

A Contest of Principles “Managers of the targeted companies, for their part, had little

interest in shareholder value; they barely understood what the words meant. What mattered to them, and what constituted “corporate value” in their view, was not the share price or any other financial measure, but the ability of the company to prosper and to grow over the long term” (Financial Times 27 June 2012)

What followed was a tournament of corporate governance beliefs. Activist hedge funds, often of foreign origin, but sometimes Japanese, used the formal legal rights conferred on shareholders by Japanese company law and by companies’ own articles of association to mount a fundamental challenge to the core of management practice in the community firm. In doing so, they drew out into the open a range of issues that had previously been uncontroversial concerning managerial autonomy and accountability, the balance in dividend policy between the distribution of income and the accumulation of reserves, and the optimal level of financial gearing for companies ((Buchanan, Chai, and Deakin 2012:5).

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Hedge Fund or Company?

When Steel Partners attempted to acquire Bull-Dog Food Company, Bull-Dog adopted a defence strategy Steel claimed illegal, but Tokyo High Court ruled the US hedge fund an “abusive acquirer.”

Similar contest between British hedge fund – The Children’s Investment Fund intervention in J-Power demonstrated aggressive tactics by activist investors not likely to succeed in Japan

However the Japanese system has become more shareholder friendly during this period, and dialogue is taking place about higher standards of governance and accountability

But the survival of the company as an enduring successful business remains more important in Japan than investors who hold shares at any given time (Financial Times 27 June 2012)

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Conclusions

Japan has much to learn from the West about corporate governance, transparency and accountability

The West has much to learn from Japan about the conception of the corporation as a community, and directors and executives commitment to enduring business success

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Takaya Seki

PhD (Econ, Kyoto University)

BSc (Imperial College, London)

Assistant Professor, Meiji University, Tokyo

Managing Director, Corporate Practice Partners, Inc., Tokyo

Professor, Reitaku University, Kashiwa, Japan

Non-Executive Director, Anritsu Corporation, Atsugi, Japan

Advisory Committee on Corporate Governance

(Ministry of Economy Trade and Industry, Financial Services Agency)

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Thomas Clarke

Director Centre for Corporate Governance

UTS Sydney