Japan Renews Governance Reform Conversation

Japanese officials, business leaders, and scholars have begun a wide-ranging review of corporate governance there, which could lead to significant changes in corporate law and governance requirements for public companies.

Two groups—one run by the Financial Services Agency, the other by the Ministry of Economy, Trade and Industry—have been working on parallel tracks for several months pondering possible improvements to Japanese governance. Most notably, both have been discussing whether to mandate the presence of outside directors on the boards of public companies, and how to define outside directors in the first place.

Kazuhito Ikeo, a finance professor at Keio University, chairs the FSA study group and serves as a member of the METI group as well. He says that while the two committees are studying overlapping topics, the cause for each group and the approaches taken are completely different.

For example, the FSA holds jurisdiction over the Financial Instruments and Exchange Act, which includes Japan’s version of the Sarbanes-Oxley Act. Therefore, it has been discussing how to maximize the value of Japan’s stock exchanges—including whether to amend that law or the country’s Corporation Law. Ikeo says Japan’s stock exchanges “suffer from a negative image” that may be “more of a bias of Japan’s corporate governance.”

The most substantial reform proposed so far is the idea requiring outside directors. That would be a sharp departure from the common practice today of employing a kansayaku, or corporate auditor. The kansayaku is an in-house executive analogous to an internal auditor, although a precise counterpart doesn’t exist in Western corporations.

Critics say the kansayaku’s position simply isn’t independent enough to ensure strong corporate governance. In an era when investors can trade on markets around the world, and when Japan’s stock exchanges depend heavily on foreign investors placing trades there, that means the kansayaku is a competitive weakness.

Saito

“Investors at home and abroad are quickly losing interest in the Tokyo stock market,” Atsushi Saito, CEO of the Tokyo Stock Exchange Group, told the FSA’s study group at a meeting in April. One factor for that low opinion, he said, has been the kansayaku system.

Japan did introduce the U.S.-style board committee system of governance in 2003, including the presence of outside directors. So far, however, it hasn’t caught on. According to the Japan Corporate Auditors Association, only 112 companies have embraced the board-committee system. Nine companies signed on in 2007 and five companies in 2008, while 20 companies that did adopt a board-committee system later returned to using a kansayaku.

“Investors do not think shareholder interest is being protected enough by the kansayaku,” Saito said. “There are many cases where the system is not working. The kansayaku needs more power.”

Saito complains that the number of corporations caught committing various infractions—insider trading, price-fixing, anti-monopoly practices, rumor-mongering, and more—hasn’t slowed down, which demonstrates that governance isn’t as effective as it needs to be. “I don’t hear many cases of the kansayaku detecting accounting scandals, although they are responsible for financial audits,” Saito said.

The Tokyo Stock Exchange had 41 companies either delisted or otherwise penalized for governance violations in the last three years, Saito said, and 59 cases in the year where a listed company’s officer or employee conducted illegal activity. “It’s embarrassing we keep on seeing these crimes and illegal activities by listed companies,” Saito said.

The kansayaku cannot select corporate executives like an outside director, nor does he or she have the right to vote at board meetings. Indeed, Saito said, it’s the other way around: Executives have the power to handpick their kansayaku. “It’s a valid concern the kansayaku is not protecting shareholder rights enough,” he said.

Opposing Outsiders

Despite those apparent shortcomings in the kansayaku system, Japan’s powerful Keidanren business association opposes requiring outside directors; many Japanese business leaders do, too. Tetsuo Seki, CEO of Shoko Chukin Bank, spoke against the idea during the FSA meeting in April.

Seki

“I think it’s asking too much to make half the board at companies outside directors or independent directors,” Seki said. “Putting things softly like ‘installing outside directors would be preferred’ might work.”

After mentioning he was a former chairman of the JCAA, however, even Seki admitted: “The kansayaku has not been very useful.” Further, he said, “I don’t think the kansayaku system is working, and I think what we need to discuss is how to make it work better.”

Mikiko Fujiwara, CEO of Alpha Associates, argued that outside directors are a looming reality, like it or not. “I can’t understand why the Keidanren and others are opposed to having an outside director,” she said. “Japan has much to lose by not even requiring one outside director on its board … It’s the demand of the time.”

Tatsuo Uemura, law professor at Waseda University specializing in corporation law and securities regulation law, sharply criticized opponents of change.

“There are many cases where the system is not working. The kansayaku needs more power.”

— Atsushi Saito,

President,

Tokyo Stock Exchange Group

“I don’t understand why Keidanren is so hung up over including one or two outside directors,” Uemura said. “This is almost odd … It is important for an executive to be able to explain [his or her] right as a manager. Having an outside director or two should give them ease in their business judgment.”

Others said a mandate for outside directors is unnecessary because executives already take steps to get outside, objective input. “There are no top executives that manage a company without considering the outwardness of matters,” said Takashi Hatchoji, an executive at Hitachi Corp. who chairs one of Keidanren’s committees and is a member of the FSA group. “There are many aspects where managers take in outside input already. To say in formality that ‘Japan is not good,’ ‘U.S. is good,’ and ‘Singapore is good’ doesn’t seem right.”

The FSA is planning to wrap up their meeting and generate a summary report by this summer. METI is aiming to end their meetings in June followed by a summary report. Ikeo says that although the government is aiming for a quick agreement on some sort of action, that may not happen—particularly on the idea of outside directors.

“There is a lot of opposition for a mandate,” he said. “It may be that we can only agree on recommending companies to include outside directors. Hopefully that will get major corporations considering such a step already to take it, and a trend will start. When there is enough momentum, we can mandate outside directors at corporations and force those that have lagged behind to take action.”

Benes

The American Chamber of Commerce in Japan strongly recommends an outside director mandate, either enshrined in Japanese law (the “hard law” approach) or promulgated as a rule by the stock exchanges (the “soft law” approach). “Either way, the definition of an outside director should be clearly defined and numbers, such as at least two outside directors per company, should be defined as well,” said Nicholas Benes, the foreign direct investment committee chair of the ACCJ.

Benes hopes Japan takes the hard-law approach rather than leave the matter to the exchanges. “The trouble with soft law by the exchanges is that they are subject to a lot of political lobbying and forces in Keidanren,” Benes said.