Fits and Starts For Japanese Corporate Governance Reform

By Sean Creehan and Paul Tierno

In this episode of our series Rethinking Asia, we spoke with Ken Hokugo, head of Corporate Governance and the director of Hedge Fund Investments at Japan’s Pension Fund Association, which manages more than $120 billion in assets. Ken is also a globally recognized expert on and strong advocate for Japanese corporate governance reform. The opinions expressed by Ken in the podcast are solely his and not those of his organization, the Pension Fund Association.

Ken discussed some of the challenges that Japan faces implementing corporate governance reform. Notably, the practice of cross-shareholdings and the lack of truly independent directors sacrifice corporate success for management stability and dampen investor confidence in Japanese stocks. Ken discusses how cross-shareholding, among other practices, is entrenched due to a host of historic and structural factors. Some of our main takeaways from our exchange with Ken include:

  • Poor market performance among Japanese stocks suggests a failure to create value and a lack of management accountability. Combined with a refusal to heed international investor concern, this has led to a lack of enthusiasm for Japanese stocks on the part of foreign investors in the past few decades.
  • The use of cross-shareholding, which is common in Japan, is often cited as the poster-child for Japan’s need for corporate governance reform. Cross-shareholding refers to the practice whereby a web of companies hold significant quantities of each other’s shares, on the promise that each will vote to approve management initiatives.
  • Holding cross-shares has origins among keiretsu, conglomerates that dominated Japan’s modern economic development. In post-World War II Japan, keiretsu used the practice to provide capital to companies involved in Japan’s re-industrialization. While the conglomerates were dissolved under government law, the practice of cross-shareholding remains, in many cases prizing management control over corporate success.
  • The appointment of independent directors to corporate boards is relatively new in Japan. A small group of appointed “independent” directors monopolizes the position for thousands of companies and remains beholden to management in most cases.
  • There are only a handful of reform success stories taking root in Japan. Beyond this, Ken believes collective engagement of domestic and foreign investors can help change corporate behavior.

Transcript

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Paul Tierno:

Welcome to Pacific Exchanges, a podcast from the Federal Reserve Bank of San Francisco. I’m Paul Tierno.

Sean Creehan:

And I’m Sean Creehan. We’re analysts in the Country Analysis Unit and we monitor financial and economic developments in Asia. Today, we continue our series Rethinking Asia, as we consider noteworthy and unusual trends in the region. We sat down with Ken Hokugo, Senior Director of Japan’s Pension Fund Association, one of Japan’s largest pension funds with $120 billion in assets under management. Ken is an expert on Japan’s corporate governance challenges and a noted skeptic on the role of strategic cross-shareholdings in Japan’s economy.

Paul Tierno:

This episode is an interesting mix of history and financial analysis. Ken helps us understand how the complex ownership relationships between Japan’s largest companies emerged in Japan’s modern economic history and how their legacy continues to impact the economy. And he has some hard-earned opinions on this topic given his role as an asset manager and a steward of many Japanese citizens’ retirement savings.

Sean Creehan:

Yes, and he certainly has some tough love in here for the leaders of Japan’s largest companies. We should note the opinions he expresses in this episode are his own and not those of the Pension Fund Association. Let’s get to the interview!

Sean Creehan:

Well, Ken, thanks for joining us today.

Ken Hokugo:

My pleasure.

Sean Creehan:

Ken, you’re a globally recognized expert on Japanese corporate governance. When some people hear the term corporate governance, they may have their eyes glaze over. But you make a really compelling case for why it’s important and how it’s such a big challenge in Japan. Before we get into your views on how corporate governance still holds back Japan’s economy, could you talk a little bit about what corporate governance actually means? And why it matters at all to an investor or a policy maker or even an ordinary consumer?

Ken Hokugo:

First, the opinion expressed here in the telephone interview is solely mine and not my organization, Pension Fund Association. There are a lot of much smarter experts on Japanese governance reform who have been in this game for much longer than I have and/or are much more knowledgeable- like academic scholars, regulators, lawyers. They’re just not as vocal or maybe shy to speak in English or just lack of true or real experiences.

I would rather be categorized as the critic and advocate for the better functioning of capital markets, or more healthy capital markets of Japan as I have only been a business person in the financial industry for a long time and have experienced most of my career in US, rather than in Japan. Dealing with US lawyers, and US regulators, yourself, and law firms and US financial institutions. All are US and I am comfortable with all English speaking people.

First of all, look at how the Tokyo Stock Exchange is doing. I am not talking about the violent moves of the past few months, but even before that, how low the average performance indicators were and are. For example, PBR (price book ratio), average PBR of a Tokyo Stock Exchange liquid shares are today around 1.2 to 1.3 today. Remember, the NIKKEI 225 is at 20,000 to 21,000 and shockingly, about a third of all listed companies today have been less than 1.0 PBR. Which means the market has been sending the message that you are less worth than what the balance sheet actually says.

I can only imagine how bad it was when Mr. Abe took office in 2012 and the NIKKEI 225 was at 9,000. What is so wrong with Japan Inc.’s shares. So, here I wear another cap of mine, the head of hedge fund investments, and I would think that Tokyo should be considered the treasure chest of the value stock. As you may know, most foreign investors do not seem to agree or even want to take a serious look. I have many contacts with the foreign managers, including hedge funds and I ask these people. Why they do not invest in Japan? Or what might change their mind?

Many have pointed out that a lack of management accountability for capital return. In turn it is a result of lack of corporate governance. And investors’ voices are too little heard. The situation has not changed much for decades and investors – domestic or foreign, institutional or retail – all are getting tired of and less passionate for investing in Japan itself and the Japanese public companies.

Paul Tierno:

Ken, I wanted to drill down a bit on this issue of corporate governance. Japan’s modern economic growth is characterized in part by keiretsu, the industrial conglomerates that dominated the Japanese economy and also had a big impact on its financial system.

What is the legacy of these conglomerates and more specifically, one of these legacies, the strategic cross-shareholdings among Japanese companies? What are these cross-shareholdings and how do they function today?

Ken Hokugo:

The keiretsu or group company, is the product of the dissolution of a conglomerate ordered by GHQ, after World War II. The origin of the conglomerate is so old, many of them are more than 300 or 400 years old. Understandably, there is no doubt that the relationship is so tight and close, even after the dissolution as if there have been no change in the corporate structure. Japan has been isolated as you know by the surrounding sea and has single sovereignty for thousands of years and that created a sense of a small community country which needed the spirit of helping each other.

It is also uncommon in the world, but the same thing has been dominant in the whole country for so long, in the case of Japan…by the way, that’s why and how National Health Insurance system have worked well. Those who make a lot of money, pay more premium. Those who do not, pay a small amount of premium. But everybody can use health insurance at the same cost. So, some foreigners have taken advantage of the system based on people’s good will these days.

This is the origin and the reason and the legacy of keiretsu. Cross-shareholding is of course an extension of helping each other and as of World War II, the country needed a lot of capital. In order to achieve that by holding shares of each other, thus apparent higher net worth, worked very well to rebuild Japan.

Today, there is no need for extra capital, but cross-shareholding is still there. You may wonder why and that may be your next question, but as the time passes, the companies realize that the stability of management team or the personnel positions are important for continuity of business. So, they decided to put their own personal agenda before the shareholders’. Continuity is not the same as sustainability. They sought stable and friendly shareholder base, thus asked the business partners to buy and hold the shares are the ticket to maintain the business relationships.

Now about half the listed companies have more than 50% friendly, stable shareholders. That’s what they admit publicly, so the number may be more.

Sean Creehan:

So Ken, just to summarize that, cross-shareholdings tend to reduce the incentives of management to respond to pressure from other interest parties, and may also inhibit competition. Has there been any previous efforts to address the problem in Japan?

Ken Hokugo:

I really want you to find and to read the archive of US Senate Committee of Finance hearing before the Subcommittee on International Trade, dated March 5, 1990. I stumbled upon this document on the internet and the top headline of the document is “The United States-Japan Structural Impediment Initiative (SII).” You may not remember, because you may be too young. Most of your listeners may be too young. But there was a time when the US and Japan was in a trade war. Not as bad as US and China today, but at the time Detroit workers smashed Japan-made cars on TV.

It’s a long document, but in a nutshell, in there, the Japanese government essentially made commitment to strengthen the power of Japan’s FTC, federal commissions so that said keiretsu group and cross-shareholdings would not impede fair competition. Needless to say, FTC does have the power to resolve such illegal situations by measures including but not limited to ordering those violators to transfer the cross-shareholdings. Arguably, this commitment and the proposed system have not worked well enough for almost 30 years. The situation has not changed in my own words.

Paul Tierno:

Why are these relationships, which you alternatively call, allegiant shareholdings, so pernicious? I wanted to see if you could explain it in a tangible way. For instance, does it undermine confidence in the stock market? Or does it stifle innovation? Beyond the corporate boardroom…first, why are they pernicious and then how beyond the corporate boardroom do we see these allegiant shareholdings playing a role?

Ken Hokugo:

The word cross-shareholding is very, very well known. And everybody in the world knows that word: cross-shareholding. But cross-shareholding does not seem to convey the true nuance of the relationship. Sometimes it doesn’t have to be cross, sometimes it is one way. Sometimes it is forced to hold. So, the word I came up with to convey the true nuance, the subtle nuance, is the word ‘allegiant shareholdings,’ or shareholders.

By having those stable, friendly or allegiant shareholders who, in aggregate, hold more than 50%, the management of those companies obtain the stability of their respective positions. Yes. So those shareholders are allegiant. Literally took an oath of allegiance to secure the business relationships, mostly. Those companies, who made business partners hold their shares actually own and control AGMs (Annual General Meetings).

Any agenda, they want shareholders majority approval to be approved. Sometimes foreign investors ask Japanese companies to increase external or independent directors but that does not mean much for obvious reasons. For the apparent appearance of increased number of external directors gives foreign investors the false illusion that Japanese corporate governance is actually improving.

If I were the CEO of such company that received such a letter, then I will pick up a phone and call a couple of friends and ask if they want to be an independent director of my company. They will say, “Yes.” And I will put down those guys, those friends, they are candidates for the AGM agenda and I know that they will be approved and by doing that, that I would have satisfied the demand from those investors. It doesn’t make much sense in terms of corporate governance.

Paul Tierno:

I wanted to get back to the tangible effects of allegiant shareholdings. I’m wondering, for instance, does allegiant shareholding contribute to any of the scandals that we’ve seen arise in major Japanese corporates? Like Toshiba, Olympus, or perhaps even Nissan?

Ken Hokugo:

Well hard to say. In a way, yes. Cooking the books and handling the headlines during their tenure, like in the cases of Olympus or Toshiba, that can be attributed to the poor governance. Because the CEO positions or the top senior executive positions tenure is typically usually two, three or four years, they wanted to do something big. Very, very prominent. Very, very outstanding things during their tenure.

But in case of Nissan, it’s just a little bit different. This is a poor governance issue, for sure. And more complex cross border corporate governance problem. Parent and subsidiary listing simultaneously is a big issue alone, by itself, but this is a cross border version. Renault is a 43% owner of Nissan, so for Nissan, corporate governance must rely on Renault, its parent company. Although it is less than 51%, they have sent multiple directors to Nissan. So, they virtually are in control of Nissan.

And Renault’s top shareholder is the French government, and the French government has a very, very big say in Renault’s management. I know for a fact that investors have been engaging Nissan for number one, lack of the second external director and then number two, succession plan for Mr. Ghosn, because he has been there for two decades. And number three, the remuneration committee or formula. Nissan has ignored those demands from the investors for a long, long time. Come to think of it, it may be because Renault did not agree.

So I understand what Nissan has gone through for the past two decades.

Sean Creehan:

Nissan seems like somewhat of a unique example, particularly given that role of French investment and French state involvement as well. But I’m wondering some of these other companies that Paul mentioned, like Toshiba or Olympus or a number of accounting scandals. The US is certainly no exception to accounting scandals, you know we saw a lot of those in the early 2000s, and of course it had a big impact and drove new regulation and legislation.

But I’m wondering do you see any of these accounting issues, are they symptomatic of issues of corporate governance at all or is that just sort of a separate issue?

Ken Hokugo:

It is very delicately intertwined problem with corporate governance. First of all, you have to realize that Japan has the lifetime employment type of a culture. In the early 2000s, it was more prominent than it is today, and each people who are ambitious enough and want to go up the ladder and want to be a part of the board of directors or the boardroom, then there’s no way that they say “no” to their senior person. That is the root problem of the “yes man” culture.

Particularly if the top guy has too much power for too long, then there’s no one who would say no to such a guy. In that aspect, that is a problem with corporate governance. Yes, Olympus issue and Toshiba issue, those are both…I think I can say that clearly most of the problem was them forming a corporate governance, or lack thereof.

Paul Tierno:

Ken, you have a pretty good position to view this issue of corporate governance, being the senior director of Japan’s Pension Fund Association, which manages more than $120 billion in assets. Can you talk about the role of the institutional investor in Japan in promoting good corporate governance, and also in just promoting general reform in the system?

Ken Hokugo:

What I have been doing so far, I have spread the word for foreign investors who are still interested in Japanese stocks, hopefully. Most of the institutional investors in Japan are affiliated to big financial groups in one way or another. They, themselves, are the companies who hold allegiant shares or their shares are held by the keiretsu parent company. The asset management arm has pledged a wall to prevent conflict of interest. Even if they want to do what they think is right, sometimes it is difficult to do so than change the system because there is always someone beyond the wall.

We have formed the collective engagement platform, similar to the investor forum of the UK and have started to engage companies collectively. Being a part of a collective…somewhat gives the comfort to the Japanese organizations. Thanks to the grayish guidelines of related laws it was very difficult to the collective engagement, but after revision of the stewardship code, where they finally, reluctantly included in principle saying “working with other investors might be beneficial,” we decided to start it through the new sentence but it means nothing legally. I would like to, if you have time, please refer to the website of that initiative, IICEF.JP. Institutional Investors Collective Engagement Forum.

As I said already, collective voices of foreign investors are desperately needed. They did not listen to Japanese, but they will listen to foreigners, as the history suggests. When it comes to business practices and exact regulations, they do in public, but that is the reality of my experience.

Sean Creehan:

Ken, earlier I think you were talking about Nissan, but you had mentioned investors looking at a company like that and saying maybe they need a second external director. One of the big elements of the recent corporate governance reform that Prime Minister Abe’s government has pushed is promoting the role of independent or external directors on Japanese boards. A number of companies have implemented this change, kind of surprising maybe to people outside of Japan to know that for a long time, there were actually no independent directors. But I’m wondering, is that a good thing? Is that making a difference? It sounds in a way that you don’t necessarily think so, but could you talk a little bit about the role of independent directors in post-reform Japanese publicly-listed companies?

Ken Hokugo:

Well, it really depends on the definition of independent. This also maybe a difference of the culture. But Japanese people listen to who pays him or her. So, “independent,” may be, but most of the cases, independent directors listen to the chairman, who has the biggest power in the organization. Typically, they do not want to say no to those people and that is also because that boys’ club or girls’ club is very, very small group of the people are occupying or monopolizing the positions of the independent directors of the 2,000 or 3,000 listed companies.

I think average, those professional external directors, have four, five or six business cards of external directors. The worst case I have seen is the 15 companies’ external directors is one guy is doing, and paid a lot of money for each. It is incredible, but they think that it is their job to be there, and to say yes to the management or the board of directors meetings. I haven’t seen…I’m sure there are a few or several good, truly working, outside, independent directors. But that is not yet.

Sean Creehan:

Ken, just to clarify…and the reason for that is that it’s not that minority shareholders can’t get together or even a larger share than that can’t get together and promote their own ideas for director. It’s because, as you say, the allegiant shareholders will just choose an “independent” director that the executives are comfortable with. Is that right?

Ken Hokugo:

Yes. That is one of the reasons, yes. Absolutely.

Paul Tierno:

Here at the Fed, I cover Korea and some of the cross-shareholdings with the keiretsu sounds a lot like what Korea experiences with the chaebol. I’m wondering if you could talk about some of the similarities between the two systems.

Ken Hokugo:

Well, in Korea, I believe that they were fortunately, or unfortunately, they were not told or forced to dissolve. They’re still in the form of a conglomerate and sure, that conglomerate have formed a lot of the companies. So, they typically have a very, very big share of each of those child or spin-off companies. But in the case of Japan, it was forced to dissolve and it was completely separate entity. But, yet, small portions were held by the former conglomerate head office, and the rest were held by the suppliers or vendors or other stakeholders.

That is the difference. It may be similar, but there is a little difference.

But at the end of the day, the good corporate governance is not possible with that situation, as long as those companies are listed and have external shareholders.

Sean Creehan:

Ken, as we wrap up, maybe ending on a positive note, if you can give us any examples where good corporate governance Japan is making a positive difference these days. And maybe a connected question if you have any suggestions for people listening that maybe are investing somehow in Japan or have some sort of influence in the process in a big or small way what people can be doing to push along some of the reform that you think needs to happen.

Ken Hokugo:

I want to pick up a best practice to show you how those guys are changing and what is the recipe for the change. But, unfortunately we do not have many good examples I can share with you here.

We know that Komatsu, for example, in a construction machinery and manufacturer, like Caterpillar in the US, has sold all their allegiant shareholdings. That is one good example. But that’s just about it. This does not mean that good governance has nothing to do with the share price, but that the slowdown of construction boom in China and other European countries.

Unfortunately, there are so few good examples that we have not observed the positive reaction to better corporate governance. That said, on the investor side, and overseas, they are slowly starting to grasp the bigger picture and I think I have been preaching a lot to the foreign investors. I’m hoping that they are getting a much better picture and from the very big perspective and then realizing the potential of Japanese market needs collectively action on this problem.

The key I want to ask the foreign investors act collectively and send letters to businesses and regulators saying that, “We do not like to see these root problems.” In extreme cases, what I may be thinking of is changing the voting policy saying that, “If you have more than x% of the net worth of the allegiant shareholding, you have to explain or otherwise we will vote against any re-election or election of directors.”

That type of drastic measure is the last resort, but that might work somehow. I’m still hopeful. I know we don’t have much time until the people get really, really tired of the slowness of Japan’s progress and they may go to the easier markets. I want to say that Japan still has the potential…Japan is still a very attractive market and attractive country. It is you who can open up the market and make Japan’s capital market function more normally, or more healthily. That’s all I want to say.

Paul Tierno:

Thank you, Ken. This has been very enlightening. We appreciate your time today.

Ken Hokugo:

My pleasure.

Sean Creehan:

We hope you enjoyed today’s conversation. For more episodes like this, you can find us on iTunes, Google Play, Stitcher, and now Spotify. If you like what you hear, please leave a review. Feedback from listeners like you will help more people find us. And for even more content, look up the Pacific Exchange blog available at frbsf.org. Thanks for joining us.


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