Japan’s first corporate-governance code come into effect Monday, less than a year after it was first proposed as part of the Abe administration’s 2014 growth strategy. Most of the first “comply or explain” statements will be filed by December.
The significance of the code is enormous. As the main “pillar” of Japan’s growth strategy, its explicit goals are to increase corporate productivity and earnings to global levels by “changing companies” and “reforming managers’ mindsets.” It encourages prudential risk-taking and “capital efficiency.” The growth strategy itself even bluntly states that if companies are sitting on mountains of cash, they should “proactively use their earnings for new capital investment, bold business realignment, mergers and acquisitions, and other deals, instead of accumulating internal reserves.”
For the first time in Japan’s history, a range of modern governance principles and “best practices” have been set forth by an authoritative body, a special committee led by the Japan Exchange Group and the Financial Services Agency. Companies will be encouraged either to comply with them or to explain to shareholders why they do not.
With transparency about actual governance practices at each company, signatories to Japan’s 2014 Stewardship Code will finally have the information they need to act as good stewards of their clients’ funds. In combination with Japan’s legal framework of strong shareholder rights (which is much stronger than in the U.S.), a virtuous cycle of accountability is being unleashed.
The peer pressure of “best practices” will likely cause companies to go beyond the minimum requirements of the law. The concept of “kaizen,” the continuous quality improvement that Japanese manufacturing companies do so well, is now being unleashed on management itself. For a firm to constantly strive to improve its governance framework is now expected. The principles-based code asks companies to do this thinking on an ongoing basis and to “engage” with their shareholders as they refine that framework….
Without fear of being pigeonholed as activists, investors will now be able to politely challenge management by pointing to authoritative paragraphs in the code and to examples set by superior companies. In essence, the code gives investors legitimate reasons to reflect their views in their proxy voting policies. What really gets the attention of boards in Japan is the potential embarrassment of low approval ratios for the directors they nominate—which often includes themselves.
What will happen over the next few years? First, the gap in the quality of corporate governance, sustainable growth and profitability between world-class companies and laggards will increase much faster than before. The former will set the example for the latter.
In the process, leading companies will invent some entirely new structures and practices (e.g., for performance-linked compensation, or for increasing return on investment) that will be instructive for companies and investors in other countries. Already Japanese bookstores are full of books on modern finance and governance.
But bringing about behavioral change in organizations takes time, and meanwhile there will be a clash of expectations between some companies and their investors. As a first-ever document in a country with three separate corporate structures, the code is unavoidably vague in certain respects. If a company says “we comply,” it may not be clear how it is complying unless it publishes its own detailed governance guidelines.
Similarly, the code appropriately refers to the interests of both shareholders and stakeholders, but like most governance codes, it doesn’t lean overly far in either direction. While obviously both are important, certain companies will continue to use the ambiguity to support obsolete or unessential “stakeholders” more than some shareholders will think is warranted.
Such clashes will generally be a healthy thing. The code will bring more rigor to discussions and will set the base for indirect collaboration between soft, helpful activist investors and institutional investors with stewardship duties.
While the code is a great first step, the government and the Financial Services Agency need to set a firm schedule for a regular (e.g., every two years) review and revision, based on what is what is working well and what is not. Germany does this annually.
Much more education and training needs to occur on both sides of the investment line. Far too few corporate directors and too few fund managers know enough about the Company Law and modern governance practices to make the government’s “constructive engagement” policies a fully successful reality.
Mr. Benes is representative director of the Board Director Training Institute of Japan. He proposed the concept of a government-supervised corporate governance code to the Liberal Democratic Party’s growth strategy committee in early 2014.
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