Abenomics - Dynamic Change in Corporate Governance in Japan

June 24, 2014


Japanese Prime Minister Shinzo Abe has touted corporate governance reform as key to revitalizing the country’s economy. Japan is seeing a new era of transparency, including a new stewardship code and amendments to the Companies Act (the “Act”) and listing rules of the Tokyo Stock Exchange (the “TSE”). It is believed that the reforms encourage foreign investment in Japanese companies, many of which are said to be undervalued. The impact of these changes is described below.

I. Corporate Governance Reform Long Overdue

Japan’s approach to corporate governance has long been criticized by foreign investors, for reasons such as the lack of independence of the board of a listed company. Previous government attempts to address such concerns included the introduction of outside directors and a new type of corporate governance based on the US model — “Company with Committees” (i’inkai secchi kaisha), comprised of an audit committee, nomination committee, and compensation committee.

However, those attempts fell short for two reasons. First, Companies with Committees impose certain unpopular burdens on companies. Because a majority of directors in each committee must be outside directors, it is difficult to find enough good candidates; moreover companies are loathe to hand over nomination and compensation rights to outsiders. As a result, only 2.2% of TSE-listed companies have adopted this type of corporate governance model. Second, the Act does not require a listed company to have an outside director unless the company adopts Companies with Committees as its corporate governance model. As of 2012, 45.3% of companies listed on the TSE lack any outside director and the average number of outside directors among the listed companies is slightly more than one while averaging more than eight board directors overall.[1] Furthermore, the phrase “outside director” under the Act is more loosely defined than in most countries. For example, a director who also serves on a parent or sister company as a director, executive officer, or employee qualifies as an outside director under the Act.

This outdated approach is due in part to the entrenched system of life-long employment whereby individuals hired after graduating high school or college remain in a company until retirement age, and jockey for positions on the board as they rise in seniority. That type of corporate culture does not encourage acceptance of laterals or outsiders in positions of authority. As such, in most Japanese companies, the board functions as the top decision-making authority, rather than monitoring and supervising the management, as is the case in most other developed countries. Japan, instead, has a “statutory auditor (kansayaku)” who is expected to assume responsibility for monitoring and supervision. However, the statutory auditor does not have power to elect or remove board directors and, as a practical matter, focuses more on compliance and prevention of illegal acts rather than on management’s performance.

With the rise of globalization and investor activism, the pressure to reform is increasing. For example, the Japanese media reported this month that 20 foreign institutional investors have sent letters to 33 major Japanese listed companies requesting an increase in the number of outside directors.

II. Promotion to Appoint Outside Directors and Introduction of Code

Amendments to the Act (the “Amendments”), which was passed by the Japanese Diet on June 20, introduce three major changes to promote a monitoring model for corporate governance:

  • The Amendments, while not explicitly mandating listed companies to appoint outside directors, take a “comply-or-explain” approach. A listed company that does not have an outside director as of the latest fiscal year end must explain at its general shareholders’ meeting “the reason why it is not reasonable for the company to have an outside director.”
  • The Amendments impose higher standards to qualify as an “outside director.” For example, directors, executive officers, or employees of the parent company or sister companies, or close relatives of directors, executive officers, or employees will no longer be considered “outside directors”. However, a company can still choose outside directors from among its major customers, suppliers and financiers, among others. Furthermore, the TSE has stricter qualifications to be an outside director (as defined as “independent officer”); for example, by disqualifying the company’s major customers, suppliers, and financiers among others under its guideline. The TSE revised its listing rules effective February 2014 obliging listed companies to make an “effort” to appoint at least one director who is an “independent officer.”
  • The Amendments introduce a company with an audit committee (kansato i’inkai secci kaisha) structure. This new type of company is meant to encourage monitoring to some extent by reducing the number of committees and their power.

As an additional layer of monitoring, Japan introduced the Principles for Responsible Institutional Investors, Japan’s Stewardship Code in February (the “Japan’s Stewardship Code”). Similar to the UK Stewardship Code, Japan’s Stewardship Code sets out seven principles and operates on a “comply-or-explain” basis. See English translation of the Japan’s Stewardship Code here.[2] An institutional investor aiming to adopt Japan’s Stewardship Code is expected to publicize its intentions on its website and submit a report to the Financial Services Agency of Japan (the “JFSA”). As of May 31, 2014, the JFSA announced that 127 institutional investors have done so.

III. Further Developments Expected

As described above, the Amendments and Japan’s Stewardship Code will facilitate transparency of corporate governance in Japanese-listed companies. Furthermore, the Abe government announced this month that the JFSA and the TSE will prepare Japan’s corporate governance code which will set out principles of corporate governance for listed companies just like the UK Corporate Governance Code, to further enhance transparency by mid-2015. The media has reported that the code is expected to take the same “comply-or-explain” approach as the Japan’s Stewardship Code and to include several principles such as (i) the number and criteria for selecting outside directors, (ii) the method to determine management compensation, and (iii) management training guidelines. The Amendments are expected to become effective on April 1, 2015.

O’Melveny will continue to monitor developments and provide further updates as significant developments unfold.

For more information about the Act, please contact the authors of this alert Yoji Maeda or Hiroki Sugita in our Tokyo office.

[1] Click here

[2] Click here

This memorandum is a summary for general information and discussion only and may be considered an advertisement for certain purposes. It is not a full analysis of the matters presented, may not be relied upon as legal advice, and does not purport to represent the views of our clients or the Firm. Yoji Maeda, an O'Melveny partner licensed to practice law in Japan and New York, Hiroki Sugita, an O'Melveny counsel licensed to practice law in Japan and New York, contributed to the content of this newsletter. The views expressed in this newsletter are the views of the authors except as otherwise noted.

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