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Understanding Japan’s Struggle to Reform the Shareholder-Management Relationship
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Understanding Japan’s Struggle to Reform the Shareholder-Management Relationship

 
 

Economic data released on August 10 confirms that after two decades of demoralizing economic stagnation, the Japanese economy has finally found its footing. The GDP expanded at a 1.9 percent annualized rate, private consumption grew 0.7 percent, and, perhaps most importantly, business spending jumped 1.3 percent. There is also a record amount of M&A activity, which implies that more corporate CEOs are proactively engaging and seeking out growth.

Much of the credit for the recovery goes to Japanese Prime Minister Shinzo Abe, whose three-pronged approach to revitalize the economy was launched in 2012. Known as Abenomics, this doctrine consists of fiscal expansion, monetary easing, and structural reform.

On the surface, Abenomics appears to have been successful. However, there are still some important (and uncomfortable) facts that undermine this apparent victory. For one, many Japanese corporations are floundering; while well-managed, they lack the necessary dynamism to grow and stay abreast of disruptive technologies and changes. For another, despite many promising corporate governance and stewardship reforms, progress has been slower than regulators may have hoped.

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The root of these issues? Perhaps it’s the dysfunctional relationship between shareholders and management.

Japanese shareholders have a lot of rights…

Interestingly, part of the problem rests with shareholders, not just corporate management. It is the (un)willingness of shareholders to engage with management in a meaningful way that has slowed the progress of corporate governance reforms, and not with whether they have the legal right to do so. Actually, the legal rights of shareholders of Japanese companies are, broadly speaking, stronger than those found in the U.S. and parts of Europe. As Nicholas Benes explains in a 2017 report for CSLA, shareholders have some surprising powers, including the right to veto board members’ pay packages and even remove them from the board.

Much of the credit for bolstering shareholders’ rights over the past 4 years goes to the Abe administration, which, through the Financial Services Agency, pushed forward historic corporate governance and stewardship reforms. A linchpin of Abe’s overall strategy, the reforms (and their subsequent revisions) included a number of measures aimed at shaking up company boards, which have a reputation for being insular and slow to embrace change. These reforms include requiring the appointment of outsiders to corporate boards, increased investment in research and development, and raising ROE.

…but what are rights if you don’t use them?

But decreeing change and implementing it are two different animals. Just because Abenomics empowers shareholders to prod management to act differently doesn’t mean they will take the bait expeditiously, if at all.

To return to the CSLA report, the lingering issue is that shareholders aren’t using their powers to hold management accountable. Even though 49 percent of TOPIX companies failed to hit a target of 8 percent return on investment over 5 years, the majority of their CEOs are supported by 95 percent of their shareholders. Benes attributes this sheepishness to several factors, including a complacency born of Japan’s stunning post-war success, as well as the stultifying nature of Japanese corporate boards.

However, when shareholder support for management does drop, management has been shifting to a more shareholder-friendly stance. Maybe they are starting to realize the power shareholders wield.

Japanese board meetings suffer from several shortcomings. First, many are prescribed, formal events with little room for deviation. It doesn’t help that many boards are an insular, inward-facing culture: many members are former or current employees, with little diversity. In such environments, it’s all too easy to veer towards groupthink and reward conservatism and caution over innovation and risk-taking. Certainly, it’s all too easy for seasoned executives, many of whom have been at one company their entire careers, to fall into an “us-versus-them” mindset where it concerns shareholder-management relations.

Additionally, many shareholder meetings are intentionally held on the same day: in 2014, nearly 900 corporations held their meetings on June 27 at 10 a.m. While this partially stems from a past history of criminal intimidation, where members of the Japanese mob would interrupt and harass executives, this threat is long gone. Instead, the practice of simultaneous board meetings persists because of its utility in keeping away pests like reporters and activist shareholders.

Structural reasons aside, shareholders who speak up are viewed as activists. And activism struggles with a very negative reputation; as chairman Yoshihiko Miyauchi of Orix Corp puts it, “all shareholders aren’t equal.” Miyauchi, like many Japanese corporate leaders, believes that shareholders are just financial tourists: transient figures who just drop in and out, collecting payouts along the way. From management’s view, activism is just a “money game”: a short-term dash for profit which undercuts the long-term stability and future prospects of a company. Even today, Miyauchi’s thinking remains the norm: while devoted to his employees and the smooth operation of his business, he remains distrustful of outsider investors with agendas.

Yet for the most part, shareholders, even the activists, aren’t financial parasites like Miyauchi makes them out to be. Many have a vested interest in changing conditions for the better. There are numerous examples of shareholders who have successfully worked with management  to increase corporate value (or even restore it, as many Japanese companies are already undervalued in the first place).

Cross-shareholding in the crosshairs  

Market participants tend to agree that  cross-shareholding, where one corporation holds stock in another corporation, is still a major impediment to improved returns for shareholders. Cross-shareholding almost always results in a lower return on equity and capital inefficiency. According to Nomura, cross-shareholding accounted for more than 30 percent of the market capitalization in the 1990s; while that number is down to about 10 percent in 2018, it is still relatively high. And from our own research, we found that proposals to unwind cross-shareholdings almost uniformly failed.

Still, there has been some progress despite the cross-shareholding impediment. For instance, there have been more votes against management, an instance of shareholders daring to wield their power. While only 11 percent of Sumitomo Corp. shareholders voted against the directors in 2014, that number soon rose to 43 percent by 2016. Further, as Goldman Sachs found, 40 percent of proposals received 10 percent of shareholder support; this might not seem like much, but considering that only 24 percent of proposals received the same level of support in 2017, this is a step forward.

Additionally, shareholder proposals for increasing dividends and share buybacks are getting more support at AGM (though they still lack the votes to get passed).

Japanese boards are also diversifying, slowly hiring more outside members and perhaps even becoming more responsive to investors—and change. Many corporations with few outside board members are coming under increased scrutiny: JP Morgan, Sumitomo Mitsui Trust, and Mitsubishi UFJ Trust and Banking have all vowed to oppose board member appointments if companies do not strive to maintain a certain percentage of outside members.

The merits of an independent board are slowly gaining acceptance. Some management teams are actively pursuing individuals with managerial experience to join their boards as independent board members. In the past, lawyers and accountants, who once served as the same firm’s statutory auditors, were converted into “independent directors”. That strategy is no longer acceptable as per the corporate governance codes. Until recently, the pool of eligible candidates to become independent directors was quite small, but as the awareness of what a truly independent board members role is more qualified candidates are stepping up for consideration.

It’s still too early to forecast how effective corporate governance reform will be in transforming the relationship between shareholders and management. Will it provide enough of a jolt to shock Japanese corporations into mending fences with their shareholders? Or will the old, entrenched way of business prevail?

It isn’t only dividend payout ratios and shareholder wealth that are at stake. Instead, this can very well determine the competitiveness and continued prosperity of individual corporations–as well as the Japanese economy at large.

David Baran has over three decades of experience investing in Asian markets. He is the co-founder and CEO of Singapore-based Symphony Financial Partners, a high-performing investment firm specializing in Japanese markets.

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