Corporate Governance in Japan: Where Will It Go from Here? Where Should It? (Part 1 of a Series)
posted by Nicholas Benes on October 24, 2016 - 8:37am
Japan has made significant steps forward in promulgating a stewardship code and a corporate governance code. Change and differentiation between companies (leaders vs. laggards) will accelerate from this point on; it is already accelerating. But how much impact will be made by the new "comply or explain"-based, potentially vastly-expanded disclosure regime, and menu of best practices that are being encouraged, will largely depend on how much investing institutions are willing to do the hard work of analyzing and comparing all this new information, assessing its true substance vs. the lack thereof, and proactively communicating with portfolio companies the kind of concrete practices and robust disclosure they would like to see next.
This report will be a series focusing on various issues that need to be understood and discussed deeply going forward, and will affect this process and the future evolution of governance in Japan.
Introduction: The Background, and the Big-Picture Problems
As the person who proposed the concept of a corporate governance code to the LDP in the fall of 2013, and informally advised both dietmen and the Financial Services Agency on its content, of course I am very happy to see that (at last), reforms have been put in place....most of all, because it occurred after a virtual drought in significant steps forward (but yes, gradual improvement of mindsets and practices) during the prior 15 years. I was of course not the only person who had sought the reforms - they were the result of the cumulative impact of advocacy by the ACGA and many others - but I was lucky in being able to prompt the LDP to seize the political moment. (For details, see here.)
But the reality is that mindsets and management do not change overnight, and the stewardship code and the corporate governance code have merely started a process of faster evolution towards better, more standardized and identifiable governance practices that will continue for the next 10 years. To understand how this process may unfold, the obstacles and potential for improvement, and the opportunities that will arise along the way, we have to consider where we started.
Where We Started
Until 2013, discussion about corporate governance in Japan was usually limited to debates about the Company Law and its minimum requirements. Since there was no corporate governance code that was detailed or widely accepted, there was in essence no "soft law" or agreed-upon concept of "best practices". As had been the case for many years, even after the "three committees" governance structure was offered up as an alternative legal structure for governance, "best practices" was not a set of widely-accepted practices. There were just "extra" practices that companies considered only if they wanted to. Corporate governance was an area where you asked your lawyer "what are the minimum corporate formalities for our type of company?" and the discussion largely ended there. Having "more effective governance practices" was not given much priority.
There are of course exceptions to this, but for 90% of firms, this was the reality.
Legal and Agency Problems
As you can see in the attached, PDF, there were (and to some extent still are) a number of legal and agency problems lurking behind the structure of the law. And when the DPJ party proposed amending the Company Law, it turned into a three-year debated about whether or not the law should require (on a mandatory basis) one outside director. To anyone who had studied how governance had evolved in most other countries, it was clear that "hard law" (the Company Law) would be insufficient, and that "soft Law", - i.e, a "comply-or-explain" corporate governance code - was needed.
The Core Problem: Many "Internal Boards" Had Become Ineffective
The good news was, many Japanese companies (those that had not lost competitiveness) had technologies and were in niches that allowed them to build up retained earnings. The bad news was, they were not necessarily re-investing this cash with the same aggressiveness they had displayed during Japan's fast-growth years. And with the withering-away of bank finance as a mainstay of Japanese companies (since they were not investing much, high ROE or not), the main voice of monitoring and de-facto governance from prior history - the banks that approved new loan requests - was gone.
Even while they competed reasonably well in the market, many such "internal boards" had lost the ability to make the tough decisions that determine long-term value and growth: divestments, restructuring, strategic redirection, capital (re)allocation. At these companies, the board had become a “meeting of division heads that fulfills minimum corporate law formalities”, not a “monitoring”, direction-setting board.
Thus, weak governance was holding back productivity growth in the Japanese economy. It was this concept, which had been very effectively spread throughout the government by the white paper written by the ACCJ's "Growth Strategy Task Force" that I led in 2010, that allowed me to successfully propose a corporate governance code for Japan. (This impact of this Task Force exceeded my wildest expectations many times over. Quietly, in 2013 the LDP adopted many of the themes and recommendations in the white paper.)
Common Features of Such Boards
Here are some of the features that are common to many such Japanese boards:
- It is hard (almost impossible) to criticize the “senior” directors (or CEO; or post-retirement "advisors")) who “promoted” you. The politics of “promotion” to the board (being valued as loyal manager) results in low awareness of responsibilities and liability of directors
- In the absence of any other standard or pressure, “directors” often think, act like managers in a hierarchy. “Aren’t the two roles the same? Instead of “maximizing”, “salary-men” often avoid risk, keep head low
- Many outside directors are friendly “cocker spaniels, not dobermans”, as Warren Buffett once quipped.("Companies are not looking for Dobermans on the board; they are looking for Cocker spaniels." ) Moreover, there are many fewer of them.
- There are few rigorous, consistently-shared concepts of “best practices” or the role/purpose of the board, aside from satisfying minimum corporate formalities
- Boards often put off the difficult decisions that are most needed: divestments, restructuring, strategic redirection, capital allocation and reallocation. Bold new ideas are viewed as disruptive and political opportunities to undermine an "opponent"
- “Director professionalism” and common skill sets are badly needed - including among outside directors. Directors often lack key skill sets (e.g. finance and understanding financial statements) needed for directing
An All-Too-Typical Board in Japan Is Surprisingly "Short-Termist"
When you sit on such boards, as I have, you would never know that the company is one whose managers pride themselves at "thinking long-term". Below, I have set forth some of the common features of such boards, most of which actually tend towards short-term thinking; scarcity of new ideas, investment projects and strategic alternatives (or debate about them); and insufficient risk-taking even when clearly warranted.
- The board is formalistic. The main objective is to “satisfy the minimum requirements of the Company Law”. Aside from that, there is no clear consensus or commitment about priorities or the purpose of board meetings
- Far too much time is spent on detailed reporting of monthly results and how we are tracking to “the annual plan.”
- Almost never looks at financial results using long-term (time series) data
- There is not nearly enough analysis/consideration of long-term trends and/or new strategic options. “Strategy” is designed to “fit” the assets and people the company presently has, without considering adding new ones, and tends to be just an extension of past strategy
- We only debate things that are largely already decided. Management does not ask for or confirm “the sense of the board” at an earlier stage
- There are so many minor items on the agenda that there is not nearly enough time to spend discussing the most important issues, ..which may not even be taken up at all
The hope is that that the corporate governance code, and engagement by investors, can transform such boards into truly "long-term-thinking", "strategic" boards. In subsequent reports in this series, I will describe the way in which the code's practices can begin to do this, and the next-stage issues that will arise (and are already arising).