Led by its impressive President, Hiromi Yamaji, the Tokyo Stock Exchange’s strategy for increasing shareholder returns has been to convince companies to do the right thing. This has been achieved by encouraging enhanced stockholder engagement and reporting, supporting a culture shift, while naming co-operative companies, thereby shaming delinquents. This approach is proving effective, with many companies improving capital-management related governance, and stocks surging.
We believe that this ‘soft’ approach has been successful in Japan because there are few Japanese companies controlled by families and, of even more relevance, current regulations already protect minority shareholders, and, as a result, there no controlling shareholder interest group deriving disproportionate financial benefit from the current regulatory framework1 .
There is also no incentive for those who control companies to keep stock prices low. Japan’s low stock prices have instead resulted from sub-optimally capitalised balance sheets, which (in turn) were mainly a consequence of conservativeness or inattention. Low Japanese stock prices were not a consequence of market concern about a previous or potential disproportionate value capture by controlling shareholders, or a deliberate intention by controlling stockholders to keep stock prices low2.
However, In South Korea, there are far more companies under the control of families, who are now deriving substantial financial benefit from the regulatory status quo. The behaviour that leads to South Korea’s low stock prices is motivated, and therefore seeking to coax South Korean controlling families into ‘being nice’ to minority stockholders is unlikely to be successful. South Korean controlling stockholders have a history of seeking to benefit at the expense of minority shareholders (and have made substantial financial gain by doing so3). By repeating their past behaviour, they stand to make further gains. (Please see: Asia ex-Japan Equity: Letter to Investors South Korea – enough is enough for a detailed analysis).
How do you persuade a controlling stockholder not to reap the benefits at the expense of minority stockholders if they are legally entitled to do so?
How do you persuade a controlling stockholder not to reap the benefits at the expense of minority stockholders if they are legally entitled to do so?
The South Korean regulatory response until now has been disappointing. We do not think this is because regulators do not know what needs to be done to reduce the ‘Korea discount’.
Controlling shareholders have resisted substantive change – including, revealingly, the acceptance of a directors’ fiduciary duty to shareholders. Regulatory changes that have been enacted over the last few years seem as if they have been drafted with the key objective of not upsetting South Korea’s controlling shareholders. To be sure, regulators have been active. They have eased registration requirements for foreign investors, restricted short selling, extended trading hours, introduced virtual annual general meetings, changed dividend record dates, and tightened lock-up periods after initial public offerings (IPOs). They have considered giving minority shareholders who are unhappy about a restructuring the right to sell shares (but at the inevitably depressed market price) back to the company. But none of these measures even begin to address the key reasons for the ‘Korea discount’, and were obviously going to be ineffectual, even ab initio4.
Regulators do not yet seem to have accepted that there are no routes to reducing the ‘Korea discount’ that do not reduce the power of controlling shareholders to exploit minority shareholders. Indeed, tentative regulatory initiatives that even hint at such a reduction in power (such as reforming takeover laws) have been stillborn, or bogged down, even when initial proposals were subsequently substantially weakened.
The regulatory changes required that would be truly effective are simple and should be uncontroversial. All that needs to happen is for South Korea’s security laws to be brought into line with those that apply in well-regulated markets.
We believe that enacting the following measures would end the ‘Korea discount’, even if South Korea’s (high) inheritance tax rate remains where it is.
‘Must Haves’ (in order of impact and importance)
- End compelled share swaps (including dilutionary new issues in exchange for shares in other companies) by requiring separate minority shareholder approval for swaps or dilutionary share issues when issued in exchange for shares5.
- Introduce a mandatory offer ‘tag along’ rule for takeovers.
- Require minority shareholder separate approval for related party transactions.
- Require shares that have been bought back (including accumulated stock held in treasury) to be cancelled, save for a reasonable percentage of uncancelled outstanding treasury stock as is customarily permitted in other, well-regulated markets.
- Codify into law a directors’ fiduciary duty to the company and to shareholders (rather than simply a duty of ‘loyalty’ to the company, which is a more ambiguous concept and subject to widely varying interpretations).
- Require an annual statement of directors (with measurable interim objectives) addressing balance sheet capital management, which should include, in particular:
- in the case of stocks trading below book value, a plan to raise stock prices to at least book value (with exceptions granted to banks, utilities and other companies that have regulated returns or capital);
- in the case of holding companies, a plan to eliminate the discount at which a stock trades to the sum of its parts;
- justifying cash balances that are high (relative to equity, total assets or market capitalisation), taking into account the specific circumstance of the company; and
- justifying the continuing use of expensive preferred stock (which can be up to twice as costly to service – relative to the cost of buying it back – as common stock).
‘Nice to Haves’
- Require the immediate disclosure of the outcome of Annual General Meeting (AGM) votes.
- Ban directors convicted of crimes involving dishonesty from managing companies, even if subsequently pardoned.
- Allow truth to be an absolute defence in defamation cases where views are publicised on shareholder/management/corporate governance issues.
- Require notices and financial reports to also be published in English.
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1 The reasons for stocks trading below book in Japan are complex, but unlike in the case of some companies in South Korea, generally do not result from a desire among controlling shareholders to keep stock prices low, and might be better explained by a survivorship-biased conservative mindset that followed the bursting of that country’s asset bubble in 1999, and low return on assets resulting from an extended period of low inflation. Relative to Korea, Japan has few family-controlled companies. Since 2000, the Horizon Kinetics Japan Founders Index shows that owner operated businesses have outperformed the MSCI Japan benchmark by approximately 4% per annum.
2 Japanese companies might also be cheap because of legacy holding or circular ownership structures.
3 Asia ex-Japan Equity: Letter to Investors | Federated Hermes Limited (hermes-investment.com)
4 Ab initio is a Latin term that means «from the beginning” or “from inception.” Ab initio is used in law to indicate that some fact existed from the start of a relevant time period.
5 Technically, a short-cut to implementing such a rule change could be to require minority shareholder approval for new share issues – either under any circumstance or when a merger, acquisition (both on the buy and sell side), restructuring or share swap is contemplated.
