Change Brewing in the Boardroom: A Proxy Adviser Assesses Corporate Governance in JapanEconomy
Tell us about your company, Institutional Shareholder Services. What kind of company is ISS, and what sort of services does it provide in Japan?
Our clients are institutional investors, and we provide information and advice to help them cast their vote at annual shareholder meetings. Having purchased stock in a corporation, they have the right to vote on proposals and appointments and other items on the ballot at the annual shareholder meeting. We do research to determine whether various ballot items are in the shareholders' long-term interests and provide voting recommendations on the basis of that judgment. We publish research reports detailing our recommendations for each company. ISS launched operations at its Japan office in 2003 in order to localize its research operations and provide better service to clients.
The amended Companies Act enacted in June 2014 has brought some new ideas to corporate governance in Japan. Can you give us your views on how governance has changed as a result?
I think Japanese ideas about corporate governance have changed in the past few years. Until pretty recently, people spoke of corporate governance in a manner more or less synonymous with "compliance." Now there's a lot more discussion of governance on a level that’s meaningful to investors. But I don’t think that the amendment of the Companies Act is the reason for that. I think there’s been a change in the environment that happened to coincide with the legal changes.
Nowadays, talk of acting in the “best interests of the shareholders” comes a bit more naturally from the mouths of Japanese executives. The same goes for terms like ROE [return on equity]. In the United States, on the other hand, the idea that the board of directors is responsible to the shareholders is pretty much taken for granted. In Japan, corporations are gradually reaching the stage where they are receptive to the idea. The governance climate is gradually changing, and I sense that foreign investors’ perception of Japanese business is changing as a result.
How have Japanese corporations been able to ignore their shareholders all this time?
It’s mainly because of the enormous role of bank lending in corporate finance, along with the impact of cross-shareholding and permanent shareholders.
I’ve vetted thousands of candidates for the position of outside director, and the vast majority of them have been former bankers. Candidates from investment houses, on the other hand, are comparatively rare. In Japan, there’s long been an assumption among businesspeople that the best financial and business minds are concentrated within the big banks, and while that dogma is gradually giving way, it’s still pretty deeply entrenched. That’s a reflection of the influence of the banks in a debt culture like Japan—as opposed to an equity culture like the United States.
Japanese business also has a tradition of cross-shareholding, in which companies with long-term relationships hold onto one another’s stock. This isn’t like buying shares as an investment; they cross-hold shares because they have this relationship, so it’s like putting the cart before the horse. With that kind of ownership structure, the company doesn’t have to worry about making the shareholders happy. Other investors might grumble, but as long as the company has all those stable shareholders, management doesn’t need to listen; it can just keep doing what it’s always done.
The revised Companies Act requires companies listed on the stock exchange to appoint outside directors or else submit an explanation as to why they haven’t done so. What’s your view on the impact of this provision?
According to our latest survey, about 90 percent of Japanese companies have brought in at least one outside director, so the impact has been quite substantial in that sense. And one thing I want to emphasize here is that the government’s approach to this reform has given Japanese executives plenty of time to think about the purpose and significance of independent directors before appointing them. If it had simply mandated outside directors by regulatory fiat, the number of such directors would have soared overnight, but it would have been a pro forma change without real meaning. If you have a company with a board of directors that functions as an executive committee, and you suddenly force it to bring in outside directors, you’re putting outsiders in a position of weighing in on day-to-day operational matters that they know nothing about. In that sort of situation, the outside director can’t make a meaningful contribution.
But I think the changes we’re seeing now are meaningful because companies have been able to move at their own pace and appoint outside directors after first considering how those directors will function on the board. As a result, they’ve been taking steps on their own initiative to optimize the board, adapting everything from meeting agendas to the frequency of meetings. You can mandate the appointment of outside directors, but you can’t mandate the frequency of board meetings or their agenda. And most important, you can’t mandate new attitudes or intentions.
A Growing Governance Gap
What’s your opinion of the new Corporate Governance Code that came into force in June 2015?
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
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.
I get the feeling that most Japanese boards have no idea as to how they’re expected to function in the future.
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.
Another recent development relating to corporate governance is the Japanese edition of the Stewardship Code, and I understand that you were actually involved in its drafting. Can you share some of your impressions from that experience?
For one thing, there was quite a bit of discussion regarding the English word “engagement.” The Japanese word taiwa [dialogue] has taken hold as the standard translation for “engagement,” but I think taiwa is narrower in meaning, so you lose some of the dimensions implicit in the term “engagement.” In the United States, shareholder involvement takes a lot of different forms, including proxy voting, letter writing, face-to-face meetings, shareholder resolutions, and even proxy fights. If the company can convince a shareholder to withdraw a resolution, then that’s considered “successful engagement.” When you focus on dialogue per se, it becomes an end in itself. That ends up costing the company money without accomplishing much, so people give up on it. In the Japanese context, I think we’re going to see an extended period of trial and error before businesses figure out how to engage shareholders meaningfully.
Japan’s Capital Productivity Problem
In October 2014, your company decided to recommend voting out the top executives of corporations that fail to maintain an average ROE of at least 5 percent over five years. Why did you adopt such a guideline? Also, the final report of the Itō Review of Competitiveness and Incentives for Sustainable Growth [April 2014], commissioned by the Ministry of Economy, Trade and Industry, calls for an ROE target of 8 percent. What’s your view on that recommendation?
Our ROE policy isn’t targeted at governance reform per se so much as the basic profitability problem that’s afflicted Japanese business for some time. The purpose is to focus on the need to boost capital productivity. We welcomed the Itō Report. A key issue in this sort of reform is the receptivity of top management to the message. If an activist hedge fund lectures executives about the importance of ROE, they’re not apt to take it as constructive criticism. But a government report is a different matter entirely. It helps set the tone of discourse.
We selected 5 percent as a reasonable absolute minimum, without regard to sector. Stocks are more risky than bonds, so unless investors can anticipate a higher return, there’s no incentive to invest in stock. After soliciting a lot of feedback from Japanese investors, we settled on the 5 percent figure.
Separating Governance and Profitability
It seems to me that in the past, discussion of corporate governance centered on oversight to ensure that management didn’t act against the interests of shareholders. But lately the focus has shifted to “proactive governance” geared to maximizing growth and shareholder profits. Do you agree with that approach?
I think enthusiasm for the word “governance” may be getting a bit overheated. We need to take a step back. It’s a mistake to link governance and corporate profitability. Can you quantify the value of appointing one outside director in terms of corporate profits? No, that’s nonsense. If merely appointing an outside director could lead directly to improved business performance, that would be terrific, but it’s not that simple. Governance is all about systemic safeguards. Think of it as risk management.
I think it helps to go back to the basic idea of a joint-stock company. Shareholders can’t run the business themselves, so they appoint directors to work on their behalf, in the expectation that the directors will oversee the senior managers who actually run the business. But if the directors are themselves members of management, then that calls their oversight into question.
Let’s say you have a Scandinavian pension fund that invests its assets in stocks around the world on behalf of the nation’s elderly. Supposing it comes down to a choice between a Japanese business and a South Korean business. If the Korean business has outside directors, and the Japanese business has only insiders on its board of directors, which is going to look like a safer investment? If we want investors to choose the Japanese business, then we need a system that meets minimum international standards.
The incorporation of an outsider’s viewpoint on the board doesn’t lead directly to higher profits. But if the board of directors changes from a group of insiders who represent the interests of the company’s divisions to an organ that rises above internal politics and performs its oversight function in a rational manner, that could open the way for the company to close down unprofitable divisions that had previously been untouchable.
As I see it, investing in corporate governance is a bit like insurance. Buying insurance doesn’t guarantee you a happy and fulfilling life. It’s the basic price you pay for eliminating the need to worry about certain risks on a daily basis, so that you’re free to focus on what you should be doing.
(Based on an interview conducted in Japanese by Takenaka Harukata on October 22, 2015. Banner photo: Interviewer Takenaka Harukata, left, with Ishida Takeyuki, executive director at Institutional Shareholder Services in Japan.)