https://www.wsj.com/articles/SB963260664134843712

July 11, 2000 12:01 am ET

By Nicholas Benes, president of Japan Transaction Partners (www.transaction.co.jp ), an investment bank specializing in merger and acquisition advisory services in Japan.

The Japanese Ministry of Justice has commenced the process of making a wholesale revision of the Commercial Code of Japan. This is a truly historic opportunity, which last occurred some 26 years ago. The battle lines are forming around issues that will directly affect the quality of corporate governance in Japan, a country which Davis Global Advisors ranked dead last among the five major capital markets of the world. (Davis’ ranking of Japan in the crucial area of board independence: 0 points out of 10.)

However, after the smoke-filled rooms are vented, will forces within the dominant Liberal Democratic Party and the Keidanren , the association of Japan’s largest and most prestigious corporations, have successfully traded obvious improvements to the Code for a disturbing array of limitations that eviscerate the healthy deterrent threat of shareholder lawsuits and directors’ liability? And, will the primary line of defense for the all-important “monitoring” functions of corporate governance once again be relegated to the ineffectual kansayaku , the country’s statutory auditors system — a containment pen in which management can control, hire and fire those in charge of oversight?

Or will Japan admit that the kansayaku system is ill and finally focus on a cure? If so, lawmakers will require the appointment of independent, non-internal directors who will have an incentive to behave as accountable fiduciaries. This, in effect, would abolish the kansayaku system, converting its so-called “statutory auditors” to directors.

With low filing fees of 8,200 yen ($77) in effect since 1993, Japan’s system for shareholder derivative lawsuits is one of the few areas in which corporate governance mechanisms are functioning well and having a healthy impact on the system. Shareholder derivative lawsuits have more than tripled in number. One of the main reasons for recent reductions in the size of many boards and the creation of executive officers was the increased threat of such suits, prompted by lower filing costs. Liability has led to increased attention to efficiency and good decision-making. Very little needs to be changed here.

However, most of the LDP’s proposal (like its precursors) is nothing but a long list of ways to restrict the initiation, success, liability and monetary impact of such suits, and to defend directors from them. The LDP and the Keidanren have been maneuvering for several years to strengthen the useless kansayaku system.

In the original postwar revision of Japan’s Commercial Code in 1950, the legal concept of the board was very similar to that found in U.S. law. The drafters assumed that many directors would be external, ensuring unbiased monitoring and oversight of management and corporate governance. But following an increase in cross-shareholdings that began in the early 1960s, many boards came to be composed mainly or entirely of internal executives. For this obvious reason there was vigorous opposition to improvements of the system from senior managers controlling key groups such as the Keidanren.

Further problems arose because the kansayaku system was continued over from the prewar system. This was intended only as a temporary measure until a deeper pool of certified public accountants and other auditors could be fostered within Japan. But as with so many stop-gap measures it failed to fade away.

Then, in 1974, in response to a major scandal and bankruptcy several years earlier, pressures mounted to reform the functions of the boards and kansayaku. The debate proceeded to consider abolishing the kansayaku system, thus curtailing the ability of managers to control their boards, creating a more independent role for board chairmen. These would have been very healthy and beneficial measures.

In a typically Japanese compromise driven by the political donations of business organizations, it was decided that the kansayaku role would be made permanent and interpreted more aggressively to include policing and monitoring. The issue was fudged in a masterpiece shell-game of accountability-shifting: kansayaku were to oversee company directors, who were charged with overseeing management, which of course was led by the same people sitting on boards, whose members were effectively appointed and terminated by the kansayaku. Make sense?

To complete this dismal picture, kansayaku do not vote. So practically speaking, the range of their potential liabilities to shareholder suits is more limited than would be the case for directors. They have no real decision-making authority and, indeed, no authority at all other than to investigate their boards. Hence, their value is directly proportional to the likelihood they would ever do that, which would be tantamount to career suicide. In practice, kansayaku are essentially appointed by company presidents, and cross-shareholders rubber-stamp the selections. Because presidents have the power to appoint and fire, the kansayaku, at best, are the neutered lap dogs of management.

Hence, what was originally a stopgap in 1950 evolved into an institutionalized accountability problem. Statutory auditors are now a costly “constituency” whose jobs politicians must worry about — even though the auditing profession now exists in strength, and outside audits have been required for large companies since 1974.

Adding further to the circular accountability, the LDP now proposes that new candidates for kansayaku must be pre-approved by other kansayaku. But as legal scholars have noted, the net legal result of this would be worse; it would simply take de facto authority away from the shareholder meeting, where approval for appointments should legally reside. In addition, the proposal would allow corporate liability in suits to be capped. Many practicing attorneys oppose the LDP’s proposal as something that would move corporate governance backwards.

The only policy that can clean up corporate governance in Japan is a two-step process. First, the law should require publicly listed companies to have more than half their board members composed of independent, “outside” directors. Second, Japan should abolish the kansayaku system and convert qualified existing statutory auditors into independent directors who sit on audit or litigation committees.

To some, this will constitute a sea change. To effect a transition, independent non-executive directors might be required to comprise a majority of key auditing, litigation and compensation committees, even if they did not make up more than half of the board.

Momentum is building for change, both within the legal community and from the membership of grassroots groups such as the Corporate Governance Forum of Japan. In this arcane field, however, private citizens cannot be blamed for hoping that corporate leaders they generally respect — on the Keidanren, for example — will espouse the right policies.

So far, however, very few of Japan’s leaders have come forth with clear views that actually improve corporate governance, and many have chosen to support proposals that go the other way. For the sake of Japan’s future, Japanese lawmakers and bureaucrats should do what is in Japan’s interests, rather than the interests of its senior corporate executives.

— From The Asian Wall Street Journal