Nicholas Benes is Representative Director of The Board Director Training Institute of Japan, which trains directors as a government-certified “public interest” nonprofit. Since 2010, he has chaired the Growth Strategy Task Force of the American Chamber of Commerce in Japan.
The Japanese government and the Tokyo Stock Exchange have taken a number of steps aimed at improving corporate governance on the assumption that this will not only improve returns for shareholders, but also improve corporate efficiency and growth prospects.
The Japan Company Law was amended so that firms were urged to add at least one outside director to their boards under a “comply or explain” rule, as is used in many countries, such as the UK. These outsiders had to be true outsiders, not people currently working at affiliates or allied firms.
A Stewardship Code for investors, also using the “comply or explain” procedure, was promulgated by the Financial Services Agency (FSA). Investors who choose to sign up need to explain things like their policies for engaging with firm management, as well as their policies for voting their proxies at the shareholders annual meetings; they cannot continue to just turn over blank proxies to management and let the latter vote for them.
The Tokyo Stock Exchange then created a Corporate Governance Code, once again based on the “comply of explain” principle, according to which firms are recommended to follow global best practices in governance, but are free to work out the details. In theory, firms that don’t follow the “comply or explain” rule could be delisted from the exchange.
Finally, an advisory committee to the Ministry of Economy, Trade and Industry (METI) urged that firms target a Return-on- Equity ratio (i.e., the ratio of profits to the value of all the shares held in the firm) of at least 8%.
We asked Nicholas Benes, who has been pushing for these kinds of reforms for decades, to discuss their impact.
TOE: How important are these governance innovations?
Benes: The most important thing is that the government has made it very clear that productivity and profitability matters, and that it believes that corporate governance is important for achieving that. The government is basically saying, “We need to make sure your pension fund is worth what it’s supposed to be in 30 years.” That’s a very different message than the government has ever sent out in the last few decades.
Taken together the two Codes will mark the beginning of the end for cross-shareholdings and similar “stable (i.e., “silent”) shareholdings.” Over the past 5-10 years, such holdings have come down very significantly. But now, after the new Codes, the banks are reducing their shareholdings in companies in accelerated fashion.
TOE: Will “comply or explain” be effective or will it let firms get away with just “talking the talk”?
Benes: Most countries use a “comply or explain” approach. The US is an outlier in taking a mandatory approach. By forcing companies to either comply or explain, you give investors a lot of detailed disclosure that reflects each company’s situation. It is then up to investors how much they actually engage in dialogue with the companies to nudge them forward, and praise those who show progress while criticizing the laggards publicly. A certain level of public shaming or praising leads to change.
TOE: ROE has got a numerator and a denominator. So, even if your profits stay the same, you can buy back a bunch of shares, and lower the amount of equity. In that case, your ROE number may look good, even though your productivity as measured by return on assets may not have improved at all.
Benes: You can only pull that trick so many times before investors wake up to it.
TOE: How are all these innovations actually going to improve corporate performance? You mentioned earlier the resistance of the industrial community.
Benes: In regard to resistance, I am referring particularly to the Keidanren [the chief business federation]. The business community itself has actually become much more fragmented and diverse on these issues than 10- 15 years ago. Keidanren tends to reflect the lowest common denominator. Keidanren is sort of a club of people with great seniority who don’t want to offend other senior people too much.
Within many firms, the reaction has been quite positive. There has been a strong level of interest at middle management levels, where we do some training. Many of these people want to take advantage of these governance changes in order to accelerate the company reforms that they wanted for a while. It’s elevated the internal discussion that is very important in Japanese companies. The top guys often will not take leadership on these issues, but if it bubbles up from below enough, they won’t say no.
TOE:You had written previously that, up to now, most of the “outside directors” were “friendly cocker spaniels, instead of Dobermans.” How will outside directors have real impact if senior management really doesn’t want to listen to them?
Benes: I borrowed that expression from Warren Buffett, who was talking about US directors. At very few firms will outside directors become Dobermans, no matter the country. What you want is cocker spaniels who bark when necessary.
And you want at least three of them. If there is just one, it’s very difficult for him or her to say anything which runs against the thinking of ten other people. But if that one person on the board says, “We ought to think harder about XYZ,” and if the person next to him says, “Yes, he’s got a point,” and the person next to him says, “Yes,” that’s really all you need to start a meaningful discussion. So firms’ concerns with their reputation can lead to the kind of board that companies should want to have.
TOE: Will outside directors have an important say on issues like compensation of executives and nomination of new directors?
Benes: Not necessarily, and that’s a problem. You need the outside directors to take the lead in helping to make decisions where the interests of executives might conflict with the best interests of the company.
TOE: What was your involvement in all this besides your role in training directors?
Benes: I proposed that a Corporate Governance Code be part of the government’s growth strategy in conversations with Diet member Yasuhisa Shiozaki, who was a key leader of the growth committee of the Liberal Democratic Party (LDP). This was back in late 2013 and early 2014. At first, Mr. Shiozaki hoped to get a mandatory requirement for one outside director put into the company law. My advice was that it would be better to legitimize the concept of “comply or explain” in that law so that we could build something with much more impact—a governance code—on that foundation. There had been arguments about the outside director rule for almost four years and I felt that sticking to a mandatory requirement would just result in years of further argument, since Keidanren refused to accept it. Shiozaki readily understood the benefits of this approach. He grabbed the ball and ran with it and convinced the FSA to start this process. And he pushed it ahead to its conclusion.
I then immediately took the FSA’s point man on this—Motoyuki Yufu [Director of the Corporate Accounting and Disclosure Division]—to dinner and gave him a memo with my ideas of what should be in the governance code. He had spent time at the OECD and was familiar with governance issues, but he had never sat on a board. He appreciated that the advice that I was giving him was based on my years of experience on various boards. And learning about practices in other countries was one of the things most useful to Mr. Yufu.
TOE: Did you find it striking that a top member of the Diet and a top official were willing to take advice from a member of the foreign business community?
Benes: I have been here for 30 years, and have been doing nothing but working on this issue for the last six years. It was the ACCJ’s Growth Strategy Task Force that I led in 2010 which had proposed many features of the “third arrow,” especially the urgent need to raise productivity. So, it’s not odd. What’s odd is that there are not more Japanese people who see it as in the interests of their own country to make detailed proposals.
TOE: A friend of mine, who is not Japanese, has been an outside director for a few months. His impression is that outside directors only make a difference if management genuinely welcomes an outsider, because he can offer a different perspective from those inside the firm. If management doesn’t really want that input, they may go through the motions, but, in substance, they’ll ignore him. He thought that, out of the 1,600 companies in the First Section of the TSE, perhaps 100 really wanted to take advantage of outside directors. Over time, he felt this would grow and become tremendously important.
Benes: I’m not going to argue whether it’s 100 vs. 300, but the number of digits is right, as opposed to 1,000 or 1,200. But I think that would be true in any country. These changes always take time.
TOE: So what will be the driver for outside directors having a real impact?
Benes: In any country, it largely depends on shareholders. Shareholders have a lot of rights in Japan, under the company law, more than in the US. If they raise their voices— as they are expected now to do under the Stewardship Code—that can change things. Management likes to get high shareholder approval ratios at their annual meetings.
Beyond that, the Corporate Governance Code includes the concept of director training, one of the things I most wanted to include. Most companies don’t have any meaningful director training program for all those inside directors. Perhaps 500-600 do engage in some sort of meaningful training, but it’s all internal. It’s kind of like the student writing his own test and then taking it. You will not come up with new practices that the President might not like. The more training that occurs, the more that directors understand what is expected of them. People here tend to act according to what is expected by society.
Creating boards that are not just rubber stamps requires getting the important strategic topics to the board sooner so there is a real chance to meaningfully engage in a back-and-forth with management. I think we’ll see a lot of changes over the coming five years.
TOE: Back in 2006, you had written that Japan was at a tipping point in terms of corporate governance. Not that much has happened since then. Why will this time be different?
Benes: I disagree with your premise. I think a lot has happened since 2006, and it is precisely those changes that enabled me to propose the governance code and other measures to get it approved. “Tipping point” doesn’t mean everything is going to happen at once. It means a point beyond which there is no return, and the next stage will definitely unfold. A lot of the changes since 2006 were under the radar and slower. An increasing number of leading companies started to self-improve their governance in order to survive in a competitive environment. We saw more disparities among companies in terms of governance and corporate strategies, more corporate restructurings. Most of all, society here now sees the necessity for reform, which was not the case 10 years ago.
TOE: Japanese companies are now so flush with cash they don’t really need to raise a lot of equity to fund investments. They can fund them internally. Can the shareholders really have power over management when the company does not need their money?
Benes: This is the key question in Japan. What made Japanese corporate governance effective in the past was that they had to go back to the banks for capital. Still, the government has made a very, very strong public message that shareholders have authority.
In the past, if a shareholder went to XYZ company, and talked about the dormant cash lying around—and asked whether the firm had plans to invest it productively or to give it back to the shareholders as dividends— he risked being labeled as an “activist” and maybe avoided. Companies would avoid meeting with investors who talked that way too much.
But nobody can label you an “activist” now, because the new Corporate Governance Code talks about using capital efficiently and you can point to the Stewardship Code and say, “I am sorry to have to ask these questions, but I am required to do so by the Stewardship Code.”
Praising and shaming have a big effect here. There will be articles in Japanese mag azines about firms with low ROEs or poor governance structures, or the firms most highly-rated by foreign investors. This kind of peer pressure—how do we stack up against our archrivals?—is going to be an extremely strong motivator.
TOE: Corporate governance may end up being better for shareholders in terms of higher ROE or higher dividends. But to what degree does corporate governance translate into better management or better strategy? At least by American standards, Canon’s corporate governance was not good, but it has been a superb firm mainly, in my view, because 70% of its sales were overseas and so competition disciplined the firm and kept it focused on core competencies. We’ll have to see how it deals with the smartphone challenge. On the other hand, Toshiba had four outside directors.
Benes: I think you are right. Competition is one of the best forms of medicine. Good governance doesn’t always translate directly into good management. There are hundreds of other factors which affect the success of your management strategy. We cannot measure the contribution of governance in the overall success of a firm. But it is also true, that rigor in one area, such as governance, often leads to rigor in other areas. Also, better governance assures investors that monitoring of management is taking place, so that a manager might not be promoted if he is mediocre. Without that, we tend to get what we had in the last couple decades, i.e., people climbing the ladder in lockstep. That promoted a bureaucratic risk-averse attitude where managers avoided sticking their necks out and firms just sat on cash.
Across the world, corporations are at a very primitive stage regarding governance practices and structures. Notions of governance only came into discussion about 50 years ago.
TOE: There was the scandal at Olympus over cooking the books and much of the Western press talked about it, not as a scandal at Olympus, but as a scandal of corporate Japan. The same is true regarding the Toshiba scandal. By contrast, people don’t talk about the much worse scandal at Volkswagen as a German problem. Are the Olympus and Toshiba scandals typical or untypical of Japanese firms?
Benes: I don’t think it is typical in the sense of accounting fraud, but I think the habits and structures that made this possible are quite common. People do not have a flexible labor market so that, if the corporate culture stinks at one firm, managers cannot go to another firm that acts more honestly. The hierarchical structure can go in a good direction if you have a rigorous, excellent leader as is the case with Kyocera. Or, it can sometimes go in a bad direction like Toshiba, because people obey orders almost as if it were a military organization.
At Toshiba, there were nine members of the board who were insiders in the firm. Many of them must have known that a lot of the stuff was going on, or sensed it, or heard things from friends over drinks at night. But they didn’t report it to the board and didn’t report it to independent members of the audit committee, as far as I know. These directors had a legal duty to report any information that might result in large damage to the company to the audit committee, and to the board as well. What prevented them from doing that? Hierarchy.
When I do compliance training with the middle-level people, I ask them: Could you report anything that you find ethically wrong or potentially harmful to the company? They all say: I could probably report it to my immediate boss because I know him personally and can trust him. But above him, probably not. I don’t personally know those people. They might go directly to the president and I might suffer some kind of retaliation.
TOE: Toshiba also had outside directors, and it was listed on the JPX 400 exchange, one of whose criteria is good governance. What does that tell us?
Benes: It tells us that director backgrounds, skill-sets, competency, and training matter. At Toshiba, the former Chief Financial Officer (CFO) chaired the audit committee. If he doesn’t want to give information to the others, it’s not going to flow to the outside directors very easily. Another member of the audit committee was the former head of Toshiba’s legal department, and such people don’t usually know much about finance or accounting. Two of the outside directors on that audit committee were former diplomats. The only outsider who had much knowledge about finance was Kiyomi Saito. She used to work at Morgan Stanley, had gone to Harvard Business School, and runs her own company, which is a listed company. I think that, had she known about doubts about the accounting treatment, there would certainly have been much earlier discussions at that committee. But, even in that case, it probably would have been extremely difficult to have a very healthy discussion if she was the only one with that sort of background (see pg. 6).
TOE: Do you think the situation in Japan is worse than what we saw at Enron, MCI/WorldCom, etc.? In the Olympus case, I saw no evidence that directors who were stealing from the stockholders put a single yen in their own pockets. Benes: That’s right. It certainly is not worse in that sense.
TOE: Do you think it’s harder to be a whistleblower in Japan than in the US? Benes: I think the tendency of directors not to be sufficiently aware enough of their own legal duties and not to act on them is worse in Japan. When they get promoted to the board, they’re still really thinking of themselves as executives in a hierarchy, where the President is their boss.
That is a different issue from whistleblowing in the general case. Former Olympus President Michael Woodford, who was ousted when he tried to investigate the accounting fraud, often says that Japan lacks a whistleblower culture. But Olympus was a case where a whistleblower actually went to somebody, in that case FACTA magazine. Toshiba was a case where the revelations came about because a whistleblower went to the SESC [Securities and Exchange Surveillance Commission], the equivalent of the American SEC [Securities and Exchange Commission]. And there are statistics showing an increase in the number of whistleblowers who go directly to the authorities because they don’t trust their own hierarchical structure not to retaliate, and because they have enough conscience to report the problem.
So, here in Japan there is an ethical base which I think is at least as good as in the US. What we don’t have in Japan is something that was put into the 2009 Dodd-Frank banking bill in the US. That law prescribes not only a prohibition on retaliation, but also that whistleblowers will get a reward if any fines result from their whistleblowing. The fact that Toshiba whistleblowers went to the SCSC—despite the lack of either protection or a reward in that case—speaks to the good ethics at the middle levels of Japanese companies.
[Originally published in the Oriental Economist, and posted here with permision. ]