By Nicholas Benes
The short story: it will not be so hard if institutional shareholders really want to topple it, and use the technique suggested here. But first, the background.
This is still the biggest defect of Japan’s equity market, and recent reforms have only made a small dent in it. At the average listed company, between 35% and 50% of the stock is owned by such holders if one includes not only firms in “cross-shareholding” relationships but also firms that unilaterally hold stock in order to win business; most holdings by banks and insurance companies; and parent companies, subsidiaries, and affiliates. Consistent with this estimate, when Japanese listed companies were asked, “what percent of your shareholders can you count to support management?” in late 2017, fully more than two-thirds of companies responded with numbers in the 30-60% range.
These “policy holdings” by “stable shareholders” represent a massive misallocation of capital that is being put at risk largely for the purpose of protecting executive teams at other companies. In 1967, Japan’s one of Japan’s most venerated managers and the founder of Panasonic, Konosuke Matsushita, minced no words in noting his concern about the then-recent rise of “stable” cross-shareholdings in these words: “If this situation continues, I think it is in no way desirable, because of the risk that once again a maldistribution of capital in our country will occur. I believe that this is not a sign of progress in capitalism; rather, it should be considered as a sign that we are moving backwards.”
With so many yes-man shareholders still around, it’s no surprise that year after year executive teams and outside directors at companies with low returns on capital are re-elected, and corporate strategies are not being focused enough to raise profitability to anywhere near full potential. Although the voices of “non-allegiant” institutional investors on such topics are louder now, they are still being drowned out by a loud chorus of dependable allegiant holders.
Fortunately, it is likely that in 2019 and beyond institutional investors will devise ways to amplify their voices and demands.
Corporate Governance Code Requirements… and Stewardship Code Limitations
As of last June, Japan’s Corporate Governance Code was strengthened to require boards to disclose their “policy for reducing” such stockholdings, and examine whether the “risks and benefits” of each holding cover the cost of capital. The Code arms investors with many more questions they can ask executives, and depending on the response, complain about. At the same time, the revised 2017 Stewardship Code countenances the concept of “collective action” by investors: discussing and coordinating engagement and voting policies with other investors in advance.
Although in 2014 the FSA set forth guidelines for the types of collective action which will not give rise to onerous “joint holder” reporting requirements, most investors are (correctly or not) afraid to take clear positions regarding collective engagement because the existing guidelines have not been clarified enough to set aside fail-safe “sanctuaries” from reporting when merely investors merely discuss their views in order to make “important suggestions” to companies.
Investors are scared that mere exchanges of views about specific companies could be interpreted as an “agreement between concert parties” whose holding percentages must be combined for purposes of the 5% hurdle for reporting as members of such a group. If that were to happen, large investors might have to file individual reports regarding a huge number of companies. So far, interpretation of the existing guidelines has not been tested, and reputation-conscious institutional investors do not want to be the first guinea pigs.
How to Topple the Wall
However, despite these concerns, Japanese and foreign institutional investors could easily take the following game-changing approach based on the two newly revised codes:
- A small group of asset managers meet to discuss how to deal with “allegiant shareholders” problem. They come to a consensus that as a general principle, an effective voting policy in Japan would be to vote against the two most senior executive directors (usually, the CEO and Chairman) up for re-election if the total “policy shareholdings” held by a company exceed 25% of the amount of net assets less cash.
This is the case at about 20% of the companies listed on the first section of the Tokyo Stock Exchange. This means this huge 25% portion of capital is not being invested in the core business, and that major volatility in the stock market could significantly erode the net worth of these companies. Such firms represent the worst offenders in Japan’s drive to make its corporate capital more efficient. Based on my analysis, large-cap companies with a higher ratio of policy stocks show a lower return on assets at a significant statistical level, ceteris paribus.
- The group agrees to jointly publish a report explaining why a voting policy like this is necessary in Japan, so as to encourage other investors to consider phasing it in after a discreet “warning period” of say, 18 months. The report states that its authors wrote it in conformance with their stewardship duties because allegiant shareholdings are a misuse of corporate resources and are distorting Japan’s entire capital market.
- The report makes it clear that it does constitute an “agreement” to vote this way in the case of any particular firm, because no specific companies were discussed by the group in the first place, and each investor owns different companies’ shares anyway. Further, the report makes it clear that in any particular case each asset manager can (of course) vote however it likes. The report states that the group has obtained legal advice that the proposed voting policy cannot possibly run afoul of the guidelines regarding collective engagement put out by the FSA in 2014, and triggers no “joint holder” reporting requirement in any way.
- The media reports about the group and its proposed voting policy. The group adds new signatories to the list as time goes by.
To the beneficiaries of the asset managers, – individuals and asset owners such as pension funds, – such a list would turn into a litmus test as to whether fund managers are truly serious about addressing Japan’s allegiant shareholder problem on their behalf.
Japan’s huge wall of allegiant shareholders currently prevents its corporate governance reforms from achieving their full potential. At this point, it has become the principal remaining cancer in its capital market. If institutional investors work together in ways like this, much of that wall can be toppled in just a few years.
How can this happen even though there are currently so many allegiant shareholders? It is simply because Japanese executives do not like receiving low voting support at shareholder meetings. It is embarrassing. If they focus their messages and intent, investors will not have to actually fire most executives in order to make their point stick.
Nicholas Benes is Representative Director of The Board Director Training Institute of Japan. In 2013, he proposed the concept of a corporate governance code led by the FSA to the LDP, and helped advise on its contents.