The Japanese economy has stagnated for well over two decades, with an ageing population, deflation, and periods of zero or negative growth. But in the last few years Prime Minister Shinzo Abe’s attempts to kickstart the economy have begun to pay off, with key corporate governance reforms playing a vital role.
Since the introduction of Japan’s Stewardship Code in 2014 and the Corporate Governance Code in 2015, dialogue between investors and Japanese companies has become more common and the governance of many companies has improved. The Ito Review in 2014 also prompted many companies to think about capital efficiency and profitability, resulting in more companies recognising the importance of value creation for shareholders.
However, many challenges remain and progress in some areas has been slow.
1) Capital management
Many Japanese companies hold on to cash, often without a clear explanation. The best capital structure depends on the circumstances of each company and is a question for the board. However, holding on to cash instead of making investments for the future does not enhance corporate value.
Many companies have raised their payout ratio and initiated share buybacks, demonstrating better awareness about capital efficiency and shareholder concerns. Yet the payout ratio is still on average around 30% lower than that of Western companies. Companies may not be able to achieve sustainable growth if they merely aim to run a business safely.
2) Board composition
Traditionally, Japanese company boards have consisted solely of management. Until recently, outside directors were uncommon and many companies had no independent directors at all. If a company did have outside directors, they often came from business partners or lenders and were not independent. Very few were in a position to monitor management from an independent standpoint and protect minority shareholders.
However, the number of companies with independent directors soared after the introduction of the Corporate Governance Code, as this required two independent directors. An increasing number of companies, particularly the larger ones, have a board that is one-third independent, but overall, boards still consist predominantly of executives.
Japanese companies also lag significantly behind their international peers in terms of board diversity. Despite an increase in the number of companies with female directors, the overall percentage is extremely low by global standards. Even companies that operate internationally and derive a majority of revenues from overseas will often have boards comprised of just Japanese nationals, who are typically over a certain age – late 50s upwards. Given this, and the large number of executive directors, boards tend to lack diversity of experience, skills and age.
An issue unique to Japan is that of strategic shareholdings, or cross-shareholdings. The most common argument against this practice relates to capital efficiency, but there are other issues, including those relating to governance.
The purpose of strategic shareholdings in most cases is to maintain good relationships with business partners, which implies that business relationships are based on shareholdings. In an extreme scenario, companies may refuse to trade with others without shareholding relationships, which obstructs fair market competition.
This makes it difficult for strategic shareholders to challenge management at the companies where they have these cross-shareholdings, even when problems are identified. These shareholders typically support management1 at shareholder meetings.
Another concern is that different shareholders receive different benefits. Institutional or retail shareholders investing for the financial return only benefit from an increase in the share price and the dividend payout, but strategic shareholders are likely to receive additional benefits through their business transactions. This is against the principle that shareholders should receive equal treatment.
In the last few decades, the volume of strategic or cross-shareholdings has fallen significantly. However, many companies continue to hold these shares and we still hear about companies being pressured to hold shares in their business partners as a condition for doing business together, which is very concerning.
4) Executive remuneration
Remuneration for senior Japanese company executives is typically lower than that in Western markets and less leveraged. Partly because compensation has not been a contentious issue in Japan, companies disclose a limited amount of information on executive remuneration. While individual disclosure is required for those who receive JPY100m (US$1m) or more, company disclosure on the conditions and performance links for bonuses and share-based pay is limited, except for a small number of companies.
In my next EOS Insights post, I will explore ways to tackle these issues.