May 12, 2019

Summary: If institutional investors take their role seriously, eliminating cross-shareholdings among companies is not difficult. Here is one practical technique to achieve this.

The “Loyal Shareholder” Problem

Although recent reforms have brought some improvements, cross-shareholdings among companies remain a major issue in the Japanese market. Executives and outside directors, who have limited incentives linked to stock performance, often remain complacent with the status quo amid the rapid changes of the market economy. “Loyal shareholders,” who simply echo management’s views, say nothing, and these executives and outside directors continue to be reappointed, creating a vicious cycle. While shareholders genuinely concerned with the company’s well-being are increasingly voicing their advice, their voices are often drowned out by the overwhelming chorus of “yes” from loyal shareholders.

According to the Financial Services Agency’s “Progress of Corporate Governance Reform” (2017), for the ratio of voting rights held by shareholders expected to support management proposals at shareholder meetings to the total voting rights, more than two-thirds of listed companies estimate this ratio to be between 30% and 60%.

Such “stable shareholders” distort capital allocation across companies through “policy shareholdings,” effectively exposing management to risk. Konosuke Matsushita, the founder of Panasonic, spoke candidly in 1967 about the then-emerging practice of cross-shareholdings for stabilization purposes:
“However, if this situation continues, there is a risk that capital will become concentrated in a few hands again in our country, which I believe is by no means desirable. I consider this not as a sign of progress in capitalism, but rather as a regression.”

しかし、状況は変化しつつあります。2019年以降、機関投資家に与えられた手段で、その発言力は大きくなっていくでしょう。つまり、コーポレートガバナンス・コードとスチュワードシップ・コードです。

The Corporate Governance Code was revised last June, requiring boards of directors to disclose their policies for reducing cross-shareholdings and to carefully examine whether the benefits and risks of individual shareholdings are commensurate with their cost of capital. Investors can use these principles as a basis to ask management various questions and, depending on the responses, express dissatisfaction if necessary. Additionally, the Stewardship Code, revised in 2017, supports “collective action,” whereby investors collaborate and coordinate on engagement and voting policies.

In 2014, the Financial Services Agency published “Organizing Legal Issues in Light of the Formulation of the Japanese Stewardship Code,” which defined collective actions that would not require filing a large-shareholding report as “joint holders.” However, many investors hesitated to engage in collective engagement because they felt there was no clear safe harbor confirming that discussing their views with other investors would not constitute a “substantial proposal action.”

Investors are concerned that simply exchanging opinions about a company could be interpreted as “agreeing to exercise voting rights jointly,” which would require combining their holdings and potentially exceeding the 5% threshold for submitting a large-shareholding report. If aggregation were required, the number of reports that large investors would need to file could be enormous. There has not yet been any case that tested this issue, and institutional investors typically do not want to be the first to become such a test case.

How to Confront Loyal Shareholders

However, domestic and foreign institutional investors can use the two revised codes effectively to break through the thick defensive line of loyal shareholders with the following approach.

Asset managers form small groups to discuss how to confront “loyal shareholders,” agreeing only on very general principles. For example, if the total value of policy shareholdings exceeds 25% of net assets minus cash and deposits, they adopt a principle of opposing the reappointment of the CEO and chairman—the two most important and effective positions in Japan. About 20% of companies listed on the First Section of the Tokyo Stock Exchange fall under this principle.
Currently, 25% of the capital in these companies is not invested in core business but is allocated to policy-driven shareholdings, leaving stock market volatility to sway corporate value. Companies that engage in such policy investments hinder the efficient allocation of capital that Japan aims for. My analysis of large-cap companies shows a statistically significant trend: all else being equal, the higher the proportion of policy shareholdings, the lower the profitability.

The investor group publishes a joint report explaining why such voting actions are necessary in Japan, encourages other investors to follow suit, and sets a grace period—say, 18 months—before actually exercising their voting rights. It is essential that the report emphasizes that this exercise of voting rights fulfills their fiduciary duties as stewards and highlights that “loyal shareholders” are effectively misallocating corporate resources and distorting Japan’s capital markets.

It is necessary to clarify in the report that the agreement is on general principles, not on exercising voting rights in the same way for specific individual stocks. Since the investment destinations of each investor in the group vary, the agreement is not intended for any particular company. Therefore, it falls within the scope of collective engagement permitted by the FSA’s 2014 “Organizing Legal Issues” guidance, and the report should also note that a legal opinion has been obtained confirming that this does not constitute “joint holders.”

このような投資家グループとその議決権行使方針は、広く報道され、賛同者が加わって、グループのリストは次第に長くなっていきます。

For beneficiaries of asset managers—such as pension funds, asset owners, and individual investors—this list serves as a litmus test, clearly showing whether the asset managers are actively addressing the loyal shareholder problem and genuinely working in the best interests of their beneficiaries.

The loyal shareholder problem is a major obstacle that hinders corporate governance reforms necessary for Japanese companies to realize their full potential. Even though reforms have gradually progressed, it remains the single biggest barrier for the capital markets. However, if institutional investors unite using the methods described above, this significant issue could be resolved within a few years.

Some may worry that the loyal shareholders are simply too numerous for this approach to be effective. However, Japanese management is highly sensitive to low support rates for reappointment proposals. If investors clearly communicate their intentions regarding voting, management will receive the message and respond appropriately well before it comes to the point of removal.

Nicholas Benes is the Executive Director of the Board Directors Training Institute of Japan (BDTI). In 2013–2014, a substantial portion of the Corporate Governance Code proposed by the Liberal Democratic Party to the Financial Services Agency and the Japan Exchange Group was based on his initiatives and advice.

(Translated by Sachiko Ichikawa) Sachiko Ichikawa is a partner attorney at Tanabe & Partners. She specializes in securities misrepresentation cases and has extensive expertise in director liability and corporate risk management.