Japan appears to be addressing its long-standing corporate governance deficit.
Japan is the land of the rising sun, but as far as corporate governance is concerned, it has been more a land of false dawns over the past 15 years or so. However, some significant changes are beginning to take effect and we may at last be seeing the rise of strong Japanese corporate governance.
Although Japan has suffered from persistent deflation and other long-running economic problems, captured by the moniker 'the lost decades' (relating to the two decades between 1991 and 2010), it continues to have many positive attractions for domestic and international investors. These include:
- The third-largest economy in the world at around $4.5 trillion, in terms of nominal GDP in 2016
- A world leader in innovation – the ratio of resident patent applications per million population in 2015 was more than three times higher than for the US, and second-highest worldwide, after South Korea. The World Economic Forum's Global Competitiveness Report for 2016–17 ranked Japan fourth globally in innovation and sophistication factors
- Some of the world's largest and most advanced producers of motor vehicles, electronic equipment, machine tools, steel and non-ferrous metals, ships, textiles and processed foods
- A well-educated and highly-skilled population
- A high savings ratio.
Yet despite its formidable strengths, Japan has been far from the leading edge of governance, whether globally or closer to home in the Asia-Pacific region, and this governance deficit may have economic implications.
For example, until recently few Japanese companies had any independent non-executive directors on their boards – this was in stark contrast to all other developed markets, not to mention several Asian emerging market economies, where independent directors have long been the norm.
For all the impressive technological innovation, Japan lags behind other advanced economies in terms of capital efficiency.
Certainly the 'Ito Review of Competitiveness and Incentives for Sustainable Growth' – heavily influenced by the Kay Review in the UK – observed in its August 2014 report that by international comparison Japan was well behind on return on equity (ROE), a metric investors regard as an important profitability indicator in relation to the efficient use of capital, over the long and short term.
"Japanese politicians, civil servants and regulators have been aware for some time that weak governance may have deterred inward investment"
The Ito Review considered that 'the first step in receiving recognition from global investors is to commit to achieving a minimum return on equity of 8% while continuing seeking to generate an ROE higher than 8%'. In spite of this, nearly 40% of Japanese listed companies are still valued below their equity book value.
Politicians from both the governing LPD and the opposition DPJ; civil servants in the Ministry of Economy, Trade and Industry; regulators from the Financial Services Agency (FSA); and the Tokyo Stock Exchange have been aware for some time that weak governance may have deterred inward investment.
Opposed to reform
Overseas investors were frustrated by the inability to unlock corporate value from their Japanese equities holdings and the Japanese stock market lagged behind its peers for many years.
Some investors, including my old firm Railpen, acknowledged weak governance was a major contributor and endorsed the groundbreaking Asian Corporate Governance Association 'White Paper on Corporate Governance in Japan' in May 2008.
So if government and the investors were not the problem, we must look elsewhere for the answer. That answer is in part companies and their trade body, the Keidanren, which opposed the idea of independent directors and were sceptical about the value of corporate governance.
The Tokyo Stock Exchange's early attempt to introduce a corporate governance code in 2004, then a common feature in markets, encountered such fierce corporate pushback that the exchange had to downgrade the document to non-binding guidance – or so-called 'principles'.
Successive Japanese governments of all political persuasions tried to improve the situation, with little success until the election of the Abe government in December 2012 and the ensuing 'Abenomics programme' to revive the sluggish economy.
This comprised 'three arrows': a massive fiscal stimulus, more aggressive monetary easing from the Bank of Japan, and structural reforms to boost Japan's competitiveness.
The third arrow included the explicit aim of enhancing corporate governance. Arguably, the first turning point for this had come in March 2010, following the previous year's election of the DPJ government, when the FSA quickly introduced new rules on proxy voting disclosure, executive remuneration above ¥100 million, and the rationale for cross-shareholding.
Momentum was lost, however, until the Abe government came into power in 2012.
The jury is still out on the overall effectiveness of Abenomics, but the strong political will has done much to shake up Japanese corporate governance.
Rather like the UK in 2010, but unlike the equivalent in the Netherlands in 2011, the launch of the Japan Stewardship Code in February 2014 was largely a top-down initiative from government, rather than a market-led one.
"Much depends on the willingness of investors both domestic and overseas to take this forward, but the initial signs were encouraging"
The Japan Stewardship Code, which drew heavily on the earlier UK code, was published in February 2014 as 'Principles for Responsible Institutional Investors'. It was subtitled 'To promote sustainable growth of companies through investment and dialogue' and set out the intention to encourage better engagement by investors, something which had not been evident in the Japanese market to date.
The exception to this was the highly effective Japan Engagement Consortium led by Governance for Owners Japan, with participants including Tokio Marine Asset Management, RPMI Railpen and others.
Much depends on the willingness of investors both domestic and overseas to take this forward, but the initial signs were encouraging. The first wave of 127 largely domestic investors made a formal public declaration of support in May 2014, including most major Japanese institutional investors and more than 25 overseas asset managers.
12 pension funds also came forward, including RPMI Railpen in the UK and the Swedish AP4 Fund as the first two overseas pension funds among the inaugural supporters.
The list continues to grow, with nearly 300 signatories. The support of domestic asset owners is key and it is encouraging to see that the Government Pension Investment Fund has stated publically its intention to make stewardship a major priority.
In every other market, the governance code for companies has preceded the investor code and it is hard to see how a stewardship code can succeed in the absence of a governance code. Many overseas investors made this point in their consultation responses on the stewardship code and the authorities have listened.
The Tokyo Stock Exchange was instructed to introduce a corporate governance code and this followed rapidly with the approval of the final draft in March 2015 in time for that year's AGM season. Naturally this includes, among much else, the need for every board to have independent outsider directors, subject to the comply or explain principle – another innovation for Japan.
A new governance code for accounting auditors in Japan was also proposed in late 2016, following the previous year's accounting scandals. Despite the recognition of the importance of regulatory reform, there is still a need for shareholders and other stakeholders to drive bottom-up change in Japanese companies.
The Stewardship Code recently underwent a triennial review and the updated version was published in Japanese and English on 29 May, after an extensive consultation process. A number of enhancements have been made.
These cover a number of areas, but the 'Council of Experts' responsible for the code were keen to ensure that changes were about substance rather than form. There is an increased emphasis under Principle 1 on the role of asset owners in encouraging their asset managers to take stewardship seriously.
Passive index managers are encouraged to do more under Principle 4 and the code now encourages collective engagement, which despite being in the UK Stewardship Code from the outset was noticeably absent from the original Japanese code in 2014.
Other changes include enhanced voting disclosure, with a clearer indication of how investors voted on specific proposals at individual companies and some indication of the rationale for their decisions.
ESG and IR
There is also greater recognition that environmental, social and governance (ESG) factors may affect the medium to long-term corporate value of investee companies.
The Ministry of Economy, Trade and Industry had come to much the same conclusion in its report in April 2015 on promoting dialogue between companies and investors on sustainable growth.
"There are already signs that investors are prepared to vote against management proposals on a bigger scale than in the past"
It specifically recommended Integrated Reporting as set out in the International Integrated Reporting Council's framework to achieve better information disclosure. Something like 300 Japanese companies have now adopted in some form, but if it is to be truly useful they will need to demonstrate some linkage between ESG and return on equity.
These changes will add to transparency and perhaps make for greater accountability. There are already signs that investors are prepared to vote against management proposals, particularly on so-called poison pills or anti-takeover measures, on a bigger scale than in the past.
It will be very interesting to see whether this was a rising trend in this year's AGM season (traditionally concentrated in a few days in late June). It is also to be hoped that the FSA will review both codes at regular intervals which it has not yet promised to do.
It is still too early to assess the extended impact of governance reform in Japan, but anecdotal signs include a greater willingness from Japanese firms to engage with investors – for example, Railpen received an increased number of meeting requests from Japanese companies visiting London since the launch of the two codes.
There is also greater activity on the part of investors themselves, with the Government Pension Investment Fund taking an impressive leadership role on the part of domestic asset owners.
There is now also more willingness to appoint independent directors, becoming the norm rather than the exception. However, there is still a way to go before they reach more than 30% of the board.
Meanwhile, companies are getting used to the idea that capital metrics like ROE do matter, even though the general target of 8% is still difficult for some companies. The Asian Corporate Governance Association's pioneering White Paper nearly 10 years ago did much to prepare the way.
Although much remains to be done, we are beginning to see encouraging progress in Japanese corporate governance.
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