MEXT scholarship 2015 (research category) research proposal

Bullseye: Is the Stewardship code a credible improvement to Japan’s corporate

governance?

On 7 April 2014, the Abe administration unveiled the newest component to its ‘third arrow’
reforms to hasten Japan’s economic recovery, the ‘Principles for Responsible Institutional
Investors’ (Stewardship Code). The Stewardship Code represents the administration’s
recognition that greater levels of foreign investment in Japanese companies are required to
compensate for the reduced opportunities for economic growth in Japan.1 In general however,
Japanese companies represent a poor option for foreign investors, with returns from Japanese
companies amongst the lowest for developed markets according to a recent poll.2 The popular
coverage of the scandals affecting Japanese companies like Olympus Corp3 and Daio paper4
only exacerbates the perception that the poor performance of Japanese companies is due to
their governance issues. The Stewardship Code takes aim at the governance problems endemic
within Japanese companies by encouraging investors with large shareholdings in those
companies (institutional investors) to publically articulate how they propose to use their
considerable influence for the purpose of ‘improving and fostering the corporate value and
sustainable growth’ of investee companies.5

The question is, will the Stewardship Code succeed in curing the governance defects that beset
Japanese companies? That is the question which is the focus of this research proposal, and a
question that requires an extended discussion, not least because of its implications for Japan’s
economy.

A break from the past

The novelty of the Stewardship Code lies in its break with the ‘American’ inspired reforms that
have consistently characterised the changes to Japan’s company legislation since the 1990’s.
Known as the ‘lost decade’ because of its deleterious effects on the overall value of Japan’s
economy, the country was forced to acknowledge that its corporate regulatory framework
granted excessive latitude to reckless directors and managers to operate their companies at a
loss.6 Reforms to increase the level of oversight for company boards were implemented, in
essence borrowing from the model of governance that had characterised American companies
since the 1980s.
1
Financial Services Agency, ‘Principles for Responsible Institutional Investors: Japan’s Stewardship Code’ 26
February 2014
2
Redmond, Tom, Kitanaka, Anna and Takeo, Yuko ‘Abe Rewrites Rules to Rouse Japan with Governance Revamp’ 10
April 2014
3
Aronson, Bruce E. ‘The Olympus Scandal and Corporate Governance Reform: Can Japan Find a Middle Ground
between the Board Monitoring Model and Management Model?’ 2012
4
Ibid, pg. 86
5
Finanical Services Agency supra, at pg. 1
6
Puchniak, Dan W.’ ‘The Japanization of American Corporate Governance’ 2007, 53
A defining feature of the American model is the primacy of the shareholders within a company
versus its employees and management (the board of directors). The board of directors is
deterred from acting contrary to shareholder interests through a number of oversight and
monitoring mechanisms that function for the benefit of preserving the primacy of a company’s
shareholders. Practically, the American model of governance has manifested itself most
publically in reforms to Japan’s companies legislation with the appointment of independent
directors and auditors to company boards as the accountability mechanism that secures the
primacy of shareholders.7

However, in the American model of governance shareholder primacy is ultimately underpinned

by the shareholders’ ability to collectively effect a change of the company’s board through a
hostile takeover.8 The existence of a hostile takeover as a credible threat to subordinate a
board to the shareholders wishes was possible only because of the other defining feature of
American corporate governance, dispersed shareholding. With a company’s ownership held by
a disparate number of shareholders (as opposed to a limited bloc of owners), a market for the
ownership of a company was able to develop, leading to the development of the hostile
takeover.9 Dispersed shareholding was the complete opposite of the Japanese corporate
landscape throughout the 1980’s and 1990’s, where a limited number of institutional investors
dominated the securities market.

Of course, the high concentration of shareholding amongst a limited number of institutional

investors during the 1990’s prevented the hostile takeover from being a central mechanism to
control company boards in Japan. Nevertheless, institutional investors were considered at the
time to be an effective accountability mechanism to regulate the board, because of their status
as major shareholders enabling access to real-time information about the company to monitor
a board’s performance, and to hold them to account if their actions devalued the company.10
While the reasons why institutional investors did not hold management accountable are
complicated, it is undeniable that institutional investors during the lost decade failed to use
their considerable influence within companies to prevent boards from running the companies
they were managing into bankruptcy.11

Despite this failure, institutional investors have not been subject to the same scrutiny and legal
reform that company boards have been forced to undergo, and have arguably increased their
presence within Japanese companies into the 21st century.12 However, the tendency for
institutional investors to be complicit in the mistakes of management continues, most visibly
demonstrated during the 2012 Olympus scandal, when it was disclosed by Olympus Corp that
management had kept operating losses off its accounting books and hid them for over a decade.

7
Aronson supra, pg. 96
8
Hostile takeover: an acquisition/purchase of the company without the approval of the company board
9
Puchiniak supra, pg. 34
10
Puchiniak supra, pg. 54
11
Puchiniak supra, pg. 67
12
林瑜、擢博士 ‘ コーポレート・ガバナンスにおける機関投資家の役割’
Tellingly, Olympus’ institutional investors were apparently ‘unaware’ of management’s
deception during this period, despite evidence that indicates it would have been impossible for
Olympus’ largest shareholders to have remained unaware.13

It is against this backdrop that the Stewardship Code has been established. In enacting the code,
the Abe administration has deviated from the approach of previous administrations to
‘Americanise’ the Japanese corporate system, and has instead chosen to fortify a defining
characteristic of the Japanese governance model, the institutional investor. The changed
approach is not without merit, with the effectiveness of independent directors and auditors in
improving corporate performance in doubt.14 However, whether the Stewardship Code is an
effective remedy to the governance issues suffered by Japanese companies remains to be seen.

Stewardship Code

As stated above, the goal of the Stewardship Code is to require institutional investors who
subscribe to the code to maximise the medium to long term value of investee companies. The
Stewardship Code articulates its requirements in seven non-binding ‘principles’, but generally
revolves around the following concepts:

1. A public policy articulating how the institutional investor intends to maximise the value
of the investee company;
2. A public policy articulating how the institutional investor intends to resolve conflicts of
interest between its clients and beneficiaries on the one hand, and the business group
the investor belongs to on the other;
3. Institutional investors are to maintain consistent dialogue with investee companies;
4. A public policy articulating how the institutional investor intends to exercise its voting
rights within the investee company.

The Stewardship Code will operate according to a ‘comply or explain’ rule – that is, if an
institutional investor subscribes to the code and contravenes one of its principles, it must
explain why it was unable to comply.

Implicit within the Stewardship Code is a recognition of the considerable influence that
institutional investors wield as owners in possession of large shareholdings in investee
companies. Practically, the Stewardship Code compels institutional investors to publically
clarify how they intend to use that influence by articulating a policy on their voting rights,
and how they intend to increase corporate value.

13
Redmond, Tom, Kitanaka, Anna and Takeo, Yuko Supra
14
Aronson supra, pg.98
 Has the Stewardship Code missed the mark?

However, the Stewardship Code does not appear to recognise the full spectrum of influence
which institutional investors are able to exert upon investee companies. Institutional
investors often have a long-standing relationship with the companies they invest in, to the
extent that employees in both the investor and investee have formed relationships that
complement the formal one between their companies.15 Thus, a significant deal of informal
influence is exerted by institutional investors upon investee companies through
backchannels. It is unclear whether the Stewardship Code will encompass the informal layer
of influence of an institutional investor, and whether or not any consequences flow from
the inability to readily articulate, in a policy, the manner in which that influence will be used.

Also, it is clear from Japan’s experience during the lost decade that institutional investors
will not always pursue the course most beneficial to shareholders in general. Shareholders
are not a homogenous group, and in particular institutional investors may wish to pursue
action that does not advance the interests of shareholders as a whole. While the
Stewardship Code appears to leave room for a divergence in interests between institutional
investors and other shareholders by recognizing that they owe a duty first to their ‘clients
and beneficiaries’16, there is an inherent tension between that duty and the purpose of the
Stewardship Code to maximise the medium to long term value of investee companies.

Research goals

Accordingly, the goals of this research proposal are as follows:

1. To determine the current function and characteristics of institutional investors in Japan;

2. To examine how the Stewardship Code will be practically implemented;
3. Compare and contrast the Stewardship Code to other reforms to corporate governance
(i.e. the appointment of independent directors/auditors);
4. To identify any defects within the Stewardship Code that inhibit institutional investors
from facilitating medium to long term increases in value in investee companies;
5. If defects are found, canvass possible reforms to the Stewardship Code.

15
Puchniak, Dan W. ‘The Efficiency of Friendliness: Japanese Corporate Governance Succeeds Again without Hostile
Takeovers’ 2008
16
Financial Services Agency supra, pg.2
Tasks to be undertaken/research timetable

Month Task Ongoing Task Potential courses*

Month 1 Consider and analyze the Monitor how  Introduction to
Month 2 development of Japan’s institutional Corporate
Month 3 companies legislation and investors who Governance
Month 4 corporate framework subscribe to  Overview of the
Month 5 since 1990; Stewardship Code concept of the
Month 6 Identify the benefits and implement the corporation
Month 7 consequences of the legal code  Division of powers
Month 8 reforms pursued by Japan in the corporation
Month 9 to improve its corporate  Directors Duties
Month 10 regulatory framework (i.e.  Enforcement of
the appointment of directors' duties
Month 11
independent directors and  Consequences of
Month 12 auditors to the board); Breach
Month 13 Identify the issues behind  Indemnification
Month 14 the failure of institutional and release
Month 15 investors to hold  Executive
Month 16 management to account remuneration
Month 17 for their actions;  Division of powers
Month 18 Consider how the in the corporation
Month 19 Stewardship Code  Shareholders
Month 20 harnesses the meetings
Month 21 characteristics of  Role of
Month 22 institutional investors to institutional
improve corporate investors
governance for investee  Corporate
companies; Regulation
 Shareholder
participation
 Regulating
corporate
governance
 Corporate social
responsibility
 Globalisation of
corporate
governance.
*Courses are not known to exist at a Japanese university, and are suggested only in broad terms
and to assist in writing/research the research proposal only