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Japan is loosening corporate governance constraints

Efforts to dismantle cross-held shares and improve board oversight are succeeding amid heightened interest from private equity and activist investors.

Something is stirring in corporate Japan.

For many years, the country’s biggest businesses have occasionally been in the spotlight, either because of their technical prowess or manufacturing success, or because of corporate scandal that has forced a storied company and its top executives into the uncomfortable glare of media scrutiny — with C-suite apologies and resignations following. But the latest spotlight is illuminating one of the most positive developments to have occurred in Japanese business in decades: the first signs of improvements in corporate governance.

The government of prime minister Shinzo Abe has been pushing an overhaul of corporate governance since 2014, when it introduced Japan’s first stewardship code, which — among other things — required transparency on voting records at fund managers. A year later, the government introduced a corporate governance code as part of a broader effort by the Abe administration to make Japanese companies more competitive.

The story of corporate Japan had hitherto been one of innovation, but also of sluggish growth, low return on investment, a hoarding of cash that could have been returned to shareholders, and weaknesses in board oversight of management (this last point was widely seen as a factor behind some of the corporate scandals that had generated headlines in recent years). The country’s governance ecosystem made it hard for shareholders to, among other things, press for changes at top Japanese companies. Further, critics said it fed a culture that was generally unresponsive to shareholder demands.

The biggest move to shake things up came in 2018 with a revision of the 2015 code. The revision aimed — in the words of the document that laid it out — to seek “sustainable corporate growth and increased corporate value over the mid- to long term.” It thus encouraged the unbundling of cross-shareholdings, which involved companies owning large chunks of each other’s shares. The phenomenon traces its roots as far back as the zaibatsu family business conglomerates that existed in 19th-century imperial Japan. Although these were to a significant extent disbanded after World War II, a different kind of business arrangement emerged over time known as keiretsu, relationships between companies, often involving cross-shareholdings as well as relationships with a core bank.

Although the Japanese banking crisis of the 1990s largely broke up ties between Japanese industry (and keiretsu) and the banks, cross-shareholdings have persisted. Often justified as a way of maintaining necessary business relationships, they nonetheless have been criticized by shareholder activists and others as locking up shareholder equity that could be more efficiently deployed elsewhere. The practice of cross-shareholding was also seen as protecting underperforming management from ouster, given that cross-shareholders could generally be relied upon to support incumbent management.

How far has Japan progressed on corporate governance today? The answer to this question is not only of interest from the perspective of a domestic audience; it is also highly relevant to foreign institutional and other investors. That is because the Abe administration’s push on corporate governance has come at a time of heightened foreign interest in Japanese corporates on the part of private equity and activist investors.

Early in 2019, corporate buyout firm KKR said Japan was now its top priority globally, citing the jettisoning of subsidiaries long held by Japanese conglomerates. A year earlier, ValueAct Holdings, a San Francisco–based hedge fund, took a large stake in Olympus, a Japanese camera and medical devices group, signaling its belief in opportunities that corporate governance reform might bring. Big foreign fund managers and corporate governance watchers generally also show significant interest in what is happening in Japan now.

Signs of progress

Taken together, these developments indicate that Japanese corporate governance is reforming and could signal a new era of greater C-suite accountability and responsiveness to shareholders — and thus a stretch of renewed business growth that could put Japan in an even more prominent position on the investor map.

Developments indicate that Japanese corporate governance is reforming and could signal a new era of greater C-suite accountability and responsiveness to shareholders.

Jamie Allen, secretary-general of the Hong Kong–based Asian Corporate Governance Association (ACGA), says Japanese companies — especially larger ones — have been busy reforming. “In general, you do see that companies are starting to realize that if they want to become global players, they need to start measuring themselves against global standards,” he said in an interview with s+b.

Companies are voluntarily following disclosure guidelines, gender equality is increasing, and there are more outside directors than before. All three factors are among criteria examined in the ACGA’s assessment of Asia’s corporate governance landscape in a biennial report. In particular, Japanese companies have made an effort to appoint more outside directors, in line with the governance code’s request that companies nominate a minimum of two outsiders to the board.

One of the companies that made it into the top 10 in the ACGA’s corporate governance rankings was Kao Corporation, a maker of chemicals and cosmetics. The company told s+b that it had benefited from having an outsider’s perspective on the board. This helped when it came to recalibrating executive pay in a country where the average salaries for executives are lower than for their counterparts elsewhere.

“Our new director advised us to raise executive remuneration, among other things,” a Kao spokesperson said. “It became easier to hire talented executives with higher pay to offer. I think these sorts of changes are happening in more Japanese companies.”

Electronics group Hitachi is perhaps the highest-profile example of change. It has in recent years developed a succession plan for its chief executive, who is an outsider — previously rare in corporate Japan. In addition, the company has determined that at least one-third of board directors need to be from outside. “Most of the independent outside directors are those who have extensive experience in the management of global enterprises,” a spokesperson told s+b. “Our goal is to receive objective criticisms or suggestions concerning what corporate management should be from different perspectives. If we try to construct our discussion on the board from that perspective, the information provided to the board will be very different, and I believe that it will contribute to better financial performance and [make the company] more sensitive to expectations from markets and customers.”

Such comments point to a significant change in mind-set, which experts say is as important as any government-led efforts to push for change through codes of conduct or even legislation. Some of the new tone has been set by the Government Pension Investment Fund (GPIF) — the Japanese pension fund and the world’s largest pension fund by assets. The GPIF has been pushing corporate governance reform behind the scenes for some time. The 2019 shareholder meetings season — which runs over the summer — featured a significant uptick in moves by Japanese companies to head off uncomfortable issues at annual general meetings (AGMs). The Financial Times reported that a record 46 Japanese corporations had pledged to drop their takeover defense strategies in anticipation of potential opposition from activist shareholders at their AGMs this year. That was more than twice the number that did so in 2018.

Looking at things from the shareholder perspective, the Financial Times, in the same report, cited Goldman Sachs estimates that the number of companies to have received shareholder proposals ahead of their AGMs had surged to a record 59, from 42 in 2018. Many proposals were related to dismissal of board directors. In particular, this change is allowing for more responsiveness to activist investors at Japanese corporations, although the number of examples in which this has been the case remains small. In June 2019, financial-services group Nomura bowed to shareholder demands by announcing a share buyback ahead of its AGM — sending its shares sharply higher. It also agreed to withdraw a proposal to nominate its chair to various board roles “to bolster governance.” The most striking recent example of activist investor influence came at Lixil, a building materials group, which in June 2019 acceded to shareholders’ demands to reinstate its former CEO — voting against the chair in so doing.

Hidetaka Aoki, a professor in policy studies at Chuo University in Tokyo, says that an increasing tendency of institutional investors to more seriously scrutinize the quality of management at companies is largely a result of the effect of the 2014 stewardship code, showing that investors who signed on to its precepts “are serious about their commitment to the sustainable improvement of corporate value through engagement.”

As a result, management was no longer deaf to activist shareholders, Aoki said, pointing to a successful attempt by ValueAct to persuade Olympus to accept three foreign board directors at the company — the first such directors there since 2011.

Still a ways to go

Yet despite these positive signs, experts say that change is moving at a slow pace. “There are still steps to take,” says the ACGA’s Allen. “For example, [companies] need to focus on the nomination of directors and CEO succession. If they had made that a stronger focus, that could have improved things.”

Indeed, one of the perennial troubles of underperforming businesses is the apparent lack of proper governance with respect to the CEO. Fundamental internal control mechanisms are missing, as are executive succession plans or sufficiently well-laid-out procedures for appointment, removal, and remuneration of executives. Aoki argues that this makes companies less competitive and more vulnerable to corporate misconduct. A CEO in Japan still has too much maneuvering space. “The traditional Japanese organizational model tends to be designed in such a way that CEOs can have a say about practically anything,” he explains.

One problem is that inside many organizations, the CEO and chair are the same person. A 2017 survey by Spencer Stuart, an executive search firm, found that more than half the companies in the S&P 500 separated the roles of CEO and chair. Although a growing number of Asian countries are making progress on this issue, Japan lags; less than 10 percent of Japanese companies choose a model that lays out such a clear division between management and the board.

Then there’s the problem of the so-called salaryman CEO. It is common practice for CEOs to select directors for boards or, even worse, pick their own successor. Promoting employees to executive positions as a way to reward loyalty is also a feature of Japan’s lifetime employment system. Another characteristic of this system is that employees tend to join the company at the same time, progress up the ranks at a similar pace, and develop bonds that last through to retirement. This tends to be a poor recipe for elevating qualified executives to the C-suite.

Gerhard Fasol, who worked as an outside director at several Japanese firms and is the director of Eurotechnology, an advisory platform that focuses on mobile and environmental technologies, says, “Engineers with [few] management skills make it to CEO, or get on the board of directors, without any relevant management experience.” The fact that executives miss such crucial management experience can lead, in turn, to ill-advised acquisitions, he believes: “This is a problem when you realize that many Japanese companies are under growing pressure to invest their pile of cash in mergers and acquisitions.” Poor corporate governance has been identified by experts as a factor behind ill-judged acquisitions by some companies.

Fasol believes that the current lack of proper governance prevents the importation of ideas from abroad at many Japanese companies. “In Japan, many companies are far too inwardly focused. Ideas don’t come only from Japan; the whole world has ideas. If you focus only on Japan, then you miss out on important information and developments,” he says.

Aoki identifies another issue, based on his research on the relationship between outside directors and corporate scandals. Companies, he says, need to take more interest in the background and specialization of outside directors, as a way of minimizing the possibility of misconduct. “In one example, one [director] was from the parent company, the other had an academic background, and another was an accountant. It turned out that the number of outside directors with accounting knowledge on the board of directors [decreased] the probability of having financial misconduct,” he says. “I found that if a company hires more financial [directors] with expertise in accounting, it will have a low probability of financial misconduct.”

One year after the revision of the corporate governance code, Fasol feels mildly positive about the changes. Although there is a growing sense of urgency among Japanese boards to appoint outsiders, “still, only 0.5 percent of Japanese board directors of stock market–listed companies are foreigners with global experience,” he points out.

Indeed, Japan fell in the ACGA’s latest corporate governance rankings, from fourth in 2016 to seventh in 2019. That can be explained, in part, the ACGA’s report says, by the fact that revision of the corporate governance and stewardship codes didn’t address some of the most intractable problems inside corporations. “In general, most companies are still hoarding cash, and they’re not managing their capital effectively and efficiently,” the ACGA’s Allen observes. “Ten years ago, the complaint was that companies weren’t willing to engage with investor capital, and despite the revision, we’re still hearing the same complaints today.”

Cross-shareholdings remain a stubborn feature of corporate Japan. Germany began unbundling a similar system of cross-shareholdings in the late 1990s. And although the revised corporate governance code does urge the unwinding of undesirable cross-shareholdings, the pace at which it is happening isn’t fast enough, says Aoki.

Finally, change may not necessarily happen in a straight line. In October 2019, foreign investors were unnerved when it emerged that Japan’s Ministry of Finance planned to lower the threshold above which investors needed to obtain approval to hold shares in companies linked to national security, to 1 percent from 10 percent. The concern was — and remains — that this move could be used to dampen shareholder activism and might discourage foreign investment in the Japanese stock market. The CEO of Japan Exchange Group, operator of the Tokyo and Osaka stock exchanges, went so far as to say that the plan — if it became policy — could mean that Japan would “lose the trust of the rest of the world.”

Much is riding on the country’s gradual steps toward improved corporate governance, and Japan is likely to remain in the spotlight for some time to come.

Author Profile:

  • Bobbie van der List is a correspondent for Dutch newspapers and magazines. Based in Tokyo, he specializes in business- and management-related topics.
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