Farmers fertilize their plots of land and sequentially rotate the crops they plant on them. They do this to improve soil health, optimize nutrients in the soil, and combat pest and weed pressures. Investors should take a cue, to improve the quality of the “land” from which they grow profits, – in other words, the capital markets.
“ESG” and “sustainability” have become the buzz words of the day. But for these concepts now gaining momentum to actually benefit companies and society, much more is needed than for huge institutional investors to simply gather massive funds using those labels. After all, just buying more land does not make it more fertile.
We need a lot of new concepts to be understood and discussed by executives and boards, and the merging of these concepts with existing ones in a synergistic fashion, thereby creating management and oversight systems that achieve what is hoped for. This is not an easy thing to do. It has never been done before.
The immensity of this challenge becomes clear when one realizes that, if anything, corporate law and its concept of limited liability create natural incentives to do the exact opposite. The harsh reality is that companies and executives make more money as long as they can get away with externalizing more risks and damage to society. We saw this quite clearly in the run-up to the 2008 financial crisis. More recently, we see it in the shocking amount of losses and pain arising from the opioid crisis, for which there will be grossly inadequate compensation.
What is needed is not just IR statements, proclaimed policies and targets. What is needed is corporate systems, values, practices, and standardized disclosure that will function so as to generate “sustainable profitability” in the world of reality. Both words are essential. No organization is “sustainable” over the long term if it will not somehow serve society so as to make enough money to reinvest and adapt, or to enable it to receive support from capital providers when it needs it.
As we teach at The Board Director Training Institute of Japan (BDTI), it is essential is not only be a “good company”, but also to generate a sufficient return on capital. Ensuring this is the job of the board. Companies fail, or become “stranded assets”, when the board fails to lead in this direction.
“G” is the driver of the ESG bus
Because of this, Governance (G) is the “driver” of every bus in the ESG bus fleet. It therefore follows that if the vast majority of bus drivers – all company boards – do not have the right values, knowledge, commitment, and discussions, then the entire concept of “ESG investing” will not work very well. Easy targets may be set, or there may be little real progress made toward achieving the most significant goals, and there will not much innovative ambition to find and tackle the next more important, difficult ones.
Without high-quality boards, the ESG boom risks becoming a massive feeding trough for rating agencies, IR/PR advisory firms, asset managers, and the media that will in the end have far less impact than is hoped.
In Japan’s case, the need to have a long-term perspective and to maintain a reputation as a good corporate citizen – to retain one’s “social license to operate” – is readily accepted by corporate executives. But this is not necessarily because the aforementioned “management and oversight systems” are in place. Especially until recently, far more often it was simply because Japanese executives wish to avoid public shame because it is so painful in this country, and because in management upper echelons Japan’s postwar “lifetime employment” seniority-ladder practices are often still largely in place.
Executive-controlled boards and the investor ecosystem stunted governance
At the same time, many Japanese companies lag behind their competitors in other developed countries on the “profitability” side of the ESG equation, because insider (executive) dominated boards inevitability tend to go easy on themselves. Put simply, Japanese managers may have high ethical standards as individuals, but Japanese corporate governance practices and related laws did not keep up with developments in other markets for several decades, and despite positive reforms since 2014, still have not reached a par with many other developed countries. The Asian Corporate Governance Association lowered Japan’s corporate governance ranking to fifth in Asia in 2020.
Moreover, for many years Japan’s domestic institutional investor ecosystem lagged in terms of understanding governance dynamics and refining their active “voice” in engagement and proxy voting. Consider that it was not the domestic institutional investor community, the FSA, or the TSE that that asked for a corporate governance code to be implemented almost seven years ago. It took a crazy foreigner like me (in 2013) to convince government leaders that a corporate governance code (CGC) was vitally necessary for Japan’s economy. When that became government policy, institutional investors agreed with it.
Not much self-reform vigor was visible in this order of events. A major part of the problem was that large groups of farmers were not making many efforts to fertilize their plots of land. This, of course, was why the Stewardship Code was one of the first reforms.
Japan is a country where regulatory policy for decades stunted the development of the best practices, case law, and habits that now support good corporate governance in many other developed countries. To its great credit, the government has been trying hard to turn the direction of these oil tankers since 2014. But most senior corporate executives serving today (including those at investing institutions as well) grew up in an entirely different ecosystem, and old governance habits die long, hard deaths even when the logic is well understood and even accepted. And developing the improved habits, values and practices that are needed to replace ingrained habits, takes time.
This is all too apparent from the fact that the upcoming revision of Japan’s CGC will only require companies in the “premium” exchange to appoint independent directors composing one-third of their board – and that. on a comply-or-explain basis, one that allows each company to set forth its own definition of independence. Domestic calls to do more than this, have been rare.
How to ensure and test for real, substantive change?
Not surprisingly, in Japan it often seems as if “ESG” has been eagerly taken up by many listed Japanese companies as a way to talk about “E” and “S” topics in IR materials (which is excellent), but often, with the simultaneous apparent intent of avoiding discussion of detailed “G” practices or implementing more robust governance disclosure. “Targeting” ways to improve is usually not discussed with regard to this third letter in the triad.
Many “buses” do not seem to have a willing, well-informed driver with a vision or even much of a logical framework to consider how to G should evolve and adapt to future needs. This of course is true in other countries also, but the “G” category is the area where Japan (even now) lags other developed markets the most.
How can Japan catch up?
On the one hand, enlightened active fund managers seem to be having a noticeable positive impact on nominal practices at many companies, with the more proactive proxy voting and engagement activities they have started to employ over the past few years.
On the other hand, “inside the castle”, actual progress and substantive change is often far too slow. Needless to say, one-third of the board – the independent directors – , will always be in a position to be outvoted. Can one really expect that they will raise topics and propose changes that provoke confrontations they know they will lose, followed by not being re-nominated?
Investors need a “litmus test” to confirm that continuous improvement (kaizen) of G is highly likely to be taking place, not just the superficial appearance of it.
Convincing the cat to “bell” itself
Part of the answer is that the organizational cat cannot be directly or completely “belled” from the outside. To a large extent, the cat (or its CEO) must come to realize that it is its own interests to learn about new methods and skill-sets, so that it can think outside of its comfortable, traditional box more often and improve itself.
In this context, farmer-investors in “education-obsessed Japan” should keep in mind that one of the least threatening things fund managers can encourage, is director and pre-director training in governance, corporate law, securities law, finance, and related topics – areas where there are huge knowledge gaps.
Investors should tell companies not only: (a) “it is for your own good! It is just education that helps your company, your valued subordinates, and it helps all of you avoid liability”; and (b) “it costs very little!”; but also (c) “if after 18 months we not see disclosure about actual training that was given to internal board candidates, we may not vote for them, because we can have no assurance that key skills are being fostered and fortified as part of your HR strategy.”
The upper-middle managers who are younger and have more flexible minds – and who never knew “the good old days” – can also play a role here. They can “manage up” and suggest to their seniors the reasons they need to be more open to change, and seed the policies and practices that are needed…and later on when they are promoted, they can bring about further changes as they are needed. Often, it is this “upper middle” tier of the corporate hierarchy that seeks to send colleagues to our training programs.
I apologize in advance for mixing metaphors! At this point, dear reader, please imagine a bus with cat passengers who are influential back-seat drivers – because in a bottom-up driven Japanese company, they are the ones who actually write all the plans and detailed policy documents, and senior executives need them to get anything done… but cannot fire them easily.
The other answer lies in arming more independent-directors-to-be with the knowledge and confidence to fulfill their expected role more effectively.
The non-obvious benefits of training and executive education
Making governance policies and thinking at large corporate organizations more effective obviously doesn’t happen instantly when a CGC is created, or when several engagement meetings with investors take place, or a famous newspaper publishes magazines on ESG and holds conferences with lots of famous speakers.
Rather, it requires a lot of internal discussions and between board members, senior management, and upper-middle management. New knowledge and perspectives from other companies or countries is vitally needed.
Offsite training programs are one of the best forums to speed this process along while at the same time fortifying vitally important informal human networks.
This is one reason why when I worked at JP Morgan many years ago, I was expected to take one training course in a new subject area every year. At training courses, new knowledge and methods were discovered. New friends and cross-border informal networks were created. Cross-fertilization of ideas took place, and new points of view emerged.
The investors that support the nonprofit I lead, The Board Director Training Institute of Japan (BDTI), are institutions or individuals who understand these benefits immediately, usually in the first meeting we have with them. It takes most of them literally minutes to conclude (for the reasons given above) that BDTI’s activities of director and pre-director training are essential to create a brighter future for many of Japan’s public companies, because they will help turn the direction of organizational oil tankers faster. We are extremely grateful for their support.
You are kidding, right?
But amazingly to me, none of our supporters or donors are large, well-recognized Japanese investing institutions, 11 years after BDTI was established, almost all of our donations, introductions, and moral support come from abroad.
“Amazingly”, I say, because I established BDTI as a special “public interest” non-profit for the express purpose of making it eminently supportable by Japanese donors, not foreign ones. I thought that being certified and then periodically inspected by the government as a non-profit organization conducting activities (governance training) considered to “serve the public interest”, – one which no single party would able to control and for which donations would bring tax benefits, – would make BDTI easier for shy Japanese institutional investors to support.
The logic of this sort of special non-profit is that by receiving donations and receiving tax benefits, it is able to offer services that serve the public interest at low cost and high quality, thereby making them more accessible and frequently utilized.
Unfortunately, since then I have learned that I was wrong on several fronts. l have learned that in Japanese asset owner or asset management organizations, it is far easier to get approval for advertising or PR than donations to a public cause, even one that fits the institution’s mission like a glove. There is little precedent for making donations of the latter type on dry topics like corporate governance (as opposed to, say, more visible activities like planting trees).
I have discovered that the vital role that executive and director training can play in improving governance, management, and corporate value is not at all obvious to senior executives at most Japanese institutional investors, who grew large in the previous era and therefore may retain some of the same habits as the corporations in which they invest. These are often very sincere, high-quality institutions who are dedicated to beneficial ESG investing just as much as foreign asset managers, and are making big moves in that direction. However, partly because many Japanese firms do not employ modern HR systems for upper middle management (talent mapping, career planning, peer reviews, skills training), many executives here do not understand the benefits of offsite training the way foreign firms do. It is simply not used as much as it is elsewhere. Also, there is less need to integrate and train lateral hires in Japan, leading to the same result.
Moreover, the fund managers or directors at Japanese asset managers have never sat on Japanese public company boards, nor have most of their seniors. Their understanding of the changing governance realities in Japanese is often insufficient – as it is also at many foreign fund managers, I should hasten to add. (At least, that is my own view after 12 years serving on various Japanese boards. If they could sit on a board, or just be a fly on the wall in a few meetings, they would gain a whole new perspective.)
Last, based on Japanese cultural “common sense”, fund managers understandably think it is rude to suggest to other Japanese companies that they hire specialists to give them governance training which they themselves have never received, or to just ask “what sort of training was given last year”?
I am not impugning the motives of the CIOs or the heads of engagement or stewardship at major investing institutions here in Japan at all. Quite to the contrary, I am sympathizing with the organizational and cultural hurdles they face.
As well, many of them may simply not know that BDTI exists, or what its mission is. Despite my notoriety after 20 years of governance advocacy, innumerable articles, and BDTI’s efforts to meet with many of them, these are large organizations… and the ESG “wave” has only started to crest in the past few years. It is incumbent on BDTI to show them our philosophy, our basic course curriculum, our four e-Learning modules, our history of offering timely seminars, and the special “advanced” course we are now designing for independent directors.
Taking your own medicine is good for you!
In any case, I have to believe – and I know! – that many Japanese asset managers have advanced enormously in the past seven years. This year, 11 years after establishing BDTI, I am hoping we will be able to land our first Japanese institutional investor as a donor or other type of supporter.
Japanese asset management firms and insurance companies benefit greatly from the existence of Japan’s large capital market, which comprises approximately 3,700 listed companies. Their growth, profitability, and ultimate sustainability depend on the health and vitality of this stock market. If they (and many other very large non-Japanese investors in this market) truly believe in the ESG principles that they espouse and their own needs to remain sustainable,… one might think it a just bit odd for none of them to support an organization that directly benefits their own futures. Yet in BDTI’s case, that is exactly what is happening with respect to the big global passive funds and Japanese investing institutions.
Whether domestic or foreign, large passive asset managers should logically want to support activities that will improve the overall market over the long-term. We can argue about the quality of their proxy voting analysis, but voting each year is one way they do this. As quasi-universal owners stuck to a certain index or an entire market, what else do they do?
To me at least, “taking one’s own ESG medicine” by doing things beyond the minimally required level of proxy voting, would seem to be a “no-brainer”. If so, rather than buying sponsor listings in national newspapers for ESG conferences for PR purposes, would it not be better to actually help improve the very market in which you invest, and upon which you most depend? … and thereby acquire a even better reputation based on good corporate citizenship and value-building? After all, we do not see farmers spending their money on ad space to acquire more land. We see them spending it on fertilizer and preventing erosion and pest invasion. Once you have increased the quality of the product you are selling, you should be able to sell more of it. Or at least, I thought that was the way that markets were supposed to work.
If large passive funds, ETFs, and Japanese institutional investors simply ask companies, “who did you train last year how long, and in what topics?”, they will find that well more than half of Japanese listed companies did virtually nothing at all other than “orientation” explanation about the company to new outside directors, and another 20% did training for less than three or four hours. These internal and executive directors are the persons who are being elected or re-elected at AGMs by both Japanese and foreign investing institutions, almost always for the sole reason that they were proposed by management.
Farmer-investors need to ask themselves, is this enough fertilizer? And is this responsible proxy voting? – in a country undergoing tremendous change, and where many sitting directors do not receive high scores on BDTI’s test of fundamental knowledge?
11 years out, I still believe that “education-obsessed Japan” and its institutional investors will eventually come to value directorship education as much as Pakistan, where more than a week of director training is essentially required by law. Japan’s market is now undergoing changes in its governance practices that are similar in magnitude to those confronted by Pakistan, from a point of departure that is far more developed but is also facing the challenges of ESG-oriented investing and true sustainability. A similar level of stress on new knowledge and training is warranted here in Japan.
In the past, Japan has usually stepped up to the plate in such situations.
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Representative Director, The Board Director Training Institute of Japan (BDTI)
The “proposer” (muse?) of Japan’s CGC and multiple other reforms, and tireless advocate for improving corporate governance so that it can help save our world for our grandchildren.