A Growing Governance Gap

INTERVIEWER

What’s your opinion of the new Corporate Governance Code that came into force in June 2015?

ISHIDA

I think we’re going to see a progressive polarization between companies that are able to make good use of the principles and those that aren’t. That’s because the code doesn’t answer companies’ questions about how to put the principles into practice. If you’re talking about appointing two outside directors, that’s clear enough, but such clear-cut principles are the exception. When it comes to trickier matters like evaluation of the board or the appointment and remuneration of executives, directors, and auditors, the code doesn’t provide concrete guidance. So, unless a company has already carefully considered these matters, it’s going to have a hard time conforming to the code. A company with experience can extract the main points from that experience and insert them into the template of a corporate governance report, but a company with no prior experience won’t know what to include.

Take the case of Omron Corp. In its annual report, it narrated the process leading up to the 2011 appointment of President Yamada Yoshihito in story form. It’s an excellent explanation that gives the reader a feeling of being an eyewitness to those events. I think a device like that can be a very effective means of communicating such decisions not only with shareholders but with employees as well. When it comes time to write up a corporate governance report, a company like Omron Corp. can draw on its experience in that way to illustrate its own thinking on such decisions. But a company that never seriously deliberated its own standards for the appointment and remuneration of senior managers— because it’s totally up to the president—will only be able to provide a very superficial semblance of compliance.

I think the three most important points in the corporate governance code are the method for determining the compensation of senior managers and directors, the method of choosing executives and directors, and evaluations of the board of directors. Japanese executives make less than their counterparts in the United States and Europe, but a larger portion of their compensation is fixed salary. Their remuneration stays pretty much the same regardless of their performance, so there’s relatively little incentive to improve or streamline corporate management.

Rethinking the Role of the Board

ISHIDA

The concept of board evaluations is probably new to a lot of people out there. It might be hard to visualize, but since outside directors are at the heart of governance, the first step to evaluating the board of directors is to honestly ask the outside directors their opinion on how well the board is functioning. In June 2015, Mitsubishi UFJ Financial Group shifted to a structure that makes use of nominating, compensation, and audit committees, and its 2015 annual report includes an interview with Outside Director Kawamoto Yūko, in which she discusses how MUFG Board of Directors has changed as a result. In the same vein, in the 2015 Integrated Report released by Mizuho Financial Group Inc., Outside Director and Chairman of the Board Ōta Hiroko talks about changes in the Board of Directors and the way it functions. The whole purpose of evaluating the board of directors is to gather this kind of feedback and use it to make improvements.

INTERVIEWER

I get the feeling that most Japanese boards have no idea as to how they’re expected to function in the future.

ISHIDA

I think you’re right. But Japanese companies aren’t alone in their confusion. Globally, ideas about governance keep shifting as the environment changes. As governance standards change, so do expectations regarding the board of directors. Currently, ISS expects Japanese companies to appoint at least one outside director. If they can’t meet that requirement, then we recommend that investors vote against the top executive.

When all the directors are insiders, the board of directors tends to function as a forum for reconciling the interests of the companies’ internal divisions. But as soon as an outside director is appointed, things start to change. If meetings are held only half as often, the nature of the agenda has to change, too, and the board naturally shifts its focus from internal politics and inter-divisional power struggles to higher-level strategic issues. When that happens, the opinion of outsiders becomes more valuable, so the outside directors play a more active role in board meetings, and the mindset of the internal directors begins to change as well.

Two outside directors are better than one, because when you have two, they can talk to one another. Just as a point of information, the international standard these days is roughly one outside director for every two insiders on the board. Japanese boards tend to have a relatively large number of directors, about nine on average, so if we could get them all to appoint two outside directors, they wouldn’t be that far from the international norm.