Nicholas Benes : 「Whither Governance in Japan? Part 2- How the Code Is Intended to Function」

A key part of my advice to LDP dietmen had been that the FSA must be in charge of the process of drafting the code (rather than METI), because the FSA is charged with protecting investors, facilitating efficient capital markets, and overseeing the stock exchanges. Since stock exchanges listing rules are usually the place where corporate governance codes get some form of “sanction” – i.e.,  if a firm doesn’t “comply or explain” at all, theoretically the exchange can de-list it – the FSA was the logical agency to lead the process.

Getting this far was a very big step forward towards creation of a sensible code, because historically METI had always succeeded in serving as the “lead agency” in charge of corporate governance policy, largely in order to channel policy “improvements” along lines that would not anger its core constituency (large companies) too much.  But on the other hand, from sitting on an FSA advisory committee, I knew well that FSA was too accustomed to the lesser role it played, and had not spent any time thinking about what provisions should be in a corporate governance code.

The memo I put together for the FSA and presented to the lead man in charge (Mr. Yufu) reads a bit like a draft code, but was only intended to be a list of what I considered the most important features of a code for Japan to be, based on having sat on four different Japanese boards of companies in trouble or transition. That is where you learn the most about what aspects of law and practice “function well” vs. those that do not. I was trying to address and “fix” governance problems I had seen occur time and time again.   Where practices to do that did not exist in Japan at all, which was frequently the case, I drew ideas from various other codes, such as those of the United Kingdom, Singapore, and Hong Kong, in addition to (of course) the OECD’s Principles of Corporate Governance, but modified them to fit with Japanese law and organizational context.

Among other things, in my memo I proposed:

• Each company should write down and publish its own “corporate governance guidelines”
• Greater clarity about the role of the board (required by the code, and set forth in guidelines)
• Detailed disclosure about compliance with the code in key areas, in reports to the TSE
• Those reports should be available on the TSE’s web site
• At least one-third or the board should be composed of independent directors
• A “lead independent director” to help guide the agenda and facilitate communications between board members
• A “lead statutory auditor”
• “Executive sessions”, which only outside directors or statutory auditors would attend
• A compensation committee composed of independent directors 
• A nomination committee composed of independent directors
• Board evaluation annually
• Director training requirements
• Disclosure of all compensation paid to former board members after their retirement
• Restrictions on board size and concurrent board positions

The italicized items above were ultimately included in the final Code (attached below), either in whole or in part, or in whittled-down form. For instance, I knew that “one-third independent directors” would never be accepted in Japan’s first corporate governance code, but by writing it in my memo, I could later say (as I did) that it was essential that Japan at least include the words “one-third” as a “stretch goal, because Singapore requires that even when a company has an independent chair, something that almost all Japanese corporations lack.”   As a result, in the code “one-third” is mentioned as a goal for companies to aspire to if they have many foreign shareholders.

The Logic of the Corporate Governance Code

The need for many of these provisions arises from the following ineluctable logic, which is common to most corporate governance systems, but exacerbated in the case of Japan by the smaller number of independent directors on boards:

• There are some decisions for which it is not proper, or would present a de-facto conflict of interest, for insiders (managers) to influence too much or participate in at all.  Obvious examples are the pricing of the MBO, the use of takeover defenses, or the setting of executive compensation. Less obvious examples are things like succession planning and nomination of directors. Especially in Japan, if the CEO and executives over-influence succession and nominations, it can lead to them protecting their “legacy” and might prevent the company from changing direction and capital allocation soon rather than too late.  Or, it can intensify “yes-man” tendencies on boards, especially since the majority of directors on Japanese boards are internal executives.

• For such decisions, independent directors should be taking the lead.  Said another way, only they can make such decisions without self-interest entering the equation. Therefore, Japan needs to require independent directors to be on boards, so that those decisions can be made on an objective and unbiased basis.  (For this reason, “Independence” and “objective” are two words that appear frequently in the corporate governance code. )

• Normally, the way this is done is to have a large number of independent directors – certainly at least three, and hopefully a majority, – on the board.  Then, governance systems further fortify the ability for such directors to think and act “independently and objectively” by forming committees of the board composed solely, or almost entirely, of independent directors.  This has many benefits:  a) most importantly, it gets the person(s) with the conflict of interest out of the room; b) there are efficiency benefits because a smaller number of persons can “specialize”, and c) by focusing the “spotlight of accountability” on a smaller number of persons, accountability for key decisions less diffused.  Shareholders know exactly who they can blame. In the most logical case, in theory, an independent majority of the board is selecting the persons who sit on the committees, so there is little chance that “non-objective” appointments will occur.

• HOWEVER, there is a fundamental problem in the case of Japan.  Since in the near term, in reality, the vast majority of companies will only have two or three independent directors on board with, say, 10 persons, what works in other countries cannot be expected to work well in Japan.  The dynamics of board politics is that it is hard – nay, usually impossible –  for only two persons to stand up against eight, especially when they were selected by those eight persons.

THEREFORE the basic logic of the code (at least, as I proposed it) is:

a) Japan needs committees even more than other countries;

b) to set the base for “committees”, Japanese companies must first appoint “multiple” independent directors – since you cannot have a committee of one, and in a pinch, two independent directors plus an outside statutory auditor could make up a committee;

c) Japanese companies need to adopt any and all devices/practices that augment the ability of independent directors to form a consensus between themselves and speak as one voice, or as powerful separate voices;

d) these practices include executive sessions, a lead independent director, board evaluation procedures, and required disclosure for compensation policy, nominations policy, and the precise reasons why each director was nominated; and

e) Japan needs director training even more than other countries, because most of these practices are new to Japan, and a lot of learning needs to take place.  (See the document attached below, English CG Code Presentation, which is a translation of a Japanese presentation I often make).

Some of the Most Important Results So Far

It was because of this logic that I (and many others) staunchly defended a requirement of “multiple” independent directors in the code in the final stages of its behind-the-scenes negotiation. You cannot have a “committee” composed of only one independent director.  Now, with “multiple” in the code, the base has been set for “committees”, which admittedly are mentioned far too vaguely and only as an “optional structure” in Principle 4-10. (See the attached copy of the Corporate Governance Code).  But at least there now is a base to build upon, leading to mounting expectations among investors

As a result, the number of listed companies with nomination committees was close to 475 at last count, up approximately eight-fold from 2014.

Similarly, with disclosure required for a broad range of comply-or-explain items, and about compensation policy, nominations policy, and the precise reasons why each director was nominated, there is now a base of information that investors can use to either better understand how the most important decisions are being made, or criticize those methods or the lack of full disclosure (if that is the case).

Although the code only requires companies to describe their “fundamental thinking about corporate governance”, rather than detailed “corporate governance guidelines” as I had proposed, there is implicit pressure from the market causing firms to write down their policies.  This is because deep down, companies realize that they are essentially lying if they say in their TSE Governance Report that they have a certain policy about nominations, or director training, etc., but that policy is not actually written down anywhere other than the TSE Governance Report itself.

This was the point I hammered away at in innumerable speeches and seminars over the past 18 months, and it seems to have gotten traction. As a result, as of the end of 2015, some 31% of all TSE-listed companies had some form of “corporate governance guidelines”.  I believe this number must surely be over 40% now but have not counted.  The most important next step is for companies to improve the quality and substance of the new practices they are adopting, and the guidelines that describe them.

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