Changing Japanese corporate governance

This paper examines the rhetoric and reality of corporate governance reform in post-bubble Japan. I argue that the process of corporate governance reform in Japan is neither one of convergence to a "global standard" nor one of inertia, and rather reflects the theme of permeable insulation taken up by other contributors to this volume. Japanese firms are increasingly adopting practices long associated with U.S. corporate governance: small boards, independent directors, and stock options. While these changes have attracted much publicity, they signify relatively little for corporate governance. Boards remain insider-dominated, and the authority of boards of directors vis a vis the CEO has been unchanged. Despite the spread of stock options, executive compensation is only minimally tied to the stock market, and disclosure of executive pay remains far from transparent. Changing Japanese corporate governance Introduction Japan is experiencing a corporate governance crisis. Corporate governance has been transformed from an obscure concern of financial economists and legal experts to front-page news. Corporate misbehavior and economic doldrums are blamed upon lack of concern for shareholders, cozy cross-shareholding relationships between firms and banks, boards of directors that look more like old boys clubs than responsible monitors, and executive compensation packages that give CEOs little incentive to improve the bottom line. Foreign institutional investors travel to Japan to promote governance reforms. Managers of large Japanese companies complain that existing governance practices hinder efforts to compete globally. On a more macroeconomic level, reforms in financial accounting regulations, sales of cross-held shares, increased foreign investment, and ongoing negotiations for a revision of the Japanese Commercial Code, all are transforming the political and economic institutions that have until now, supported a distinctive, Japanese system of corporate governance. These changes in corporate governance are extremely important to understanding political and economic change in the Japanese economy. A corporate governance system comprises a wide range of practices and institutions, from accounting standards and laws concerning financial disclosure, to executive compensation, to size and composition of corporate boards. A corporate governance system defines who owns the firm, and dictates the rules by which economic returns are distributed between shareholders, employees, managers, and other stakeholders. As such, a nation's corporate governance regime has deep implications for firm organization, employment systems, trading relationships, and capital markets. Thus, changes in Japan's system of corporate governance are likely to have important consequences for the structure and conduct of Japanese business. As with many aspects of economic and political change in Japan, debate on the prospects of corporate governance reform tends to be framed around two extremes of convergence and inertia. Those who predict convergence argue that global capital and product markets will inevitably drive Japanese firms to a "global standard"--or more specifically, American practice. Some proponents of the opposite viewpoint argue optimistically that existing Japanese governance institutions are effective and do not require dramatic reform. Others argue pessimistically that inertia and fear of upsetting the status quo make change impossible. In this paper, I argue that neither convergence nor inertia fully explains the trajectory of corporate governance reform in Japan. Rather, corporate governance reform in 1990's Japan reflects the theme of permeable insulation that runs though this volume. Firms are increasingly adopting practices long associated with U.S. corporate governance: small boards, independent directors, and stock options. They argue that Japanese firms must adopt a "global standard" of corporate governance to assure that Japanese firms remain competitive in a global economy. Yet these changes are of far less consequence than the amount of publicity they have received suggests. Stock option grants are small, and boards, though reduced in size, remain insiderdominated. Japanese firms have been markedly reluctant to make changes that would increase the influence of outsiders on boards, and true independent directors remain rare. Firms have also been reluctant to implement changes that would undermine the authority of the company president, or shacho, to appoint and dismiss directors, approve their compensation levels, and select his own successor. In this chapter, I examine two pillars of corporate governance: executive compensation and board composition. I explore the introduction of stock options (legalized in 1997), and several aspects of board reform, including the shikko yakuin, or corporate executive officer, system, independent directors, and the ongoing debate over the merits of the kansayaku, or statutory auditors. The material presented comes from my field research and includes information collected from extensive interviews with corporate executives, bureaucrats, academics, investors, and others involved in governance reform. I have also relied considerably on the extensive written documentation on corporate governance, ranging from proposals for reform to opinion surveys, that has emerged from various study groups and organizations over the last decade. Corporate governance In its broadest sense, corporate governance refers to a complementary set of legal, economic, and social institutions that protect the interests of a corporation's owners. In the Anglo-American system of corporate governance these owners are shareholders. The concept of corporate governance presumes a fundamental tension between shareholders and corporate managers (Berle and Means, 1932; Jensen and Meckling, 1976). While the objective of a corporation's shareholders is a return on their investment, managers are likely to have other goals, such as the power and prestige of running a large and powerful organization, or entertainment and other perquisites of their position. In this situation, managers' superior access to inside information and the relatively powerless position of the numerous and dispersed shareholders of the American firm, mean that managers are likely to have the upper hand. Economists have offered a number of solutions for this agency problem between shareholders and managers. In general, these solutions fall under the categories of incentive alignment, monitoring, and discipline. Incentives of managers and shareholders can be aligned through practices such as stock options or other market-based compensation (Fama and Jensen, 1983). Monitoring by an independent and engaged board of directors assures that managers behave in the best interests of the shareholders (Fama and Jensen, 1983). CEO's who fail to maximize shareholder interests can be removed by concerned boards of directors, and a firm that neglects shareholder value is disciplined by the market through takeover (Jensen and Ruback, 1983). In the late 1980's and early 1990's, researchers' interests moved beyond the boundaries of the U.S. to consider the distinctly different governance regimes found around the world (LaPorta, Lopez de Silanes, et al, 1998; Charkham 1994, Roe 1994). Japan was a particular focus for this interest, since Japanese corporate governance diverged so widely from U.S. practice (Schaede; 1994). In contrast to the U.S., Japanese managers did not take it for granted that shareholders were the ultimate owners of the firm. Rather, a Japanese firm sought to balance a wide range of stakeholders, including creditors, employees, managers, and business partners (Fukao 1995; Aoki 1990. Specialists on the Japanese economy identified a number of mechanisms that, taken together, constituted an effective system to protect the interests of these stakeholders. Influential main banks monitored firm performance, and provided both discipline and resources to those in financial trouble (Sheard, 1994; Hoshi, Kashyap et al. 1991; Hoshi, Kashyap et al. 1990). Closely linked business groups, or keiretsu, used ownership stakes and interlocking directorships to monitor not only their investment in each other, but to assure long-term, mutually beneficial business relationship (Gerlach 1992; Gilson and Roe 1993). Administrative guidance (gyosei shido), and a system of amakudari, in which retired government officials assumed post-retirement careers as private sector managers assured that relevant ministries kept close tabs on firm behavior (Schaede, 1994). Until quite recently, experts contrasted the Japanese system of corporate governance favorably with the Anglo-American system (Roe, 1994). The Japanese system, they argued, encouraged patient capital and close sharing of information between firms and their shareholders, which in turn promoted innovation, stability in employment, and interfirm cooperation (Gerlach, 1992). Conversely, the American system, with its shortsighted shareholders, hostile takeovers, and greedy executives held back growth and innovation (Porter 1992). A corporate governance revolution? The perception of Japanese corporate governance as effective and worthy of imitation around the world, changed drastically with the burst of the bubble economy in the early 1990's. As the 1990's progressed, coopureeto gabanansu or kigyo tochi, terms previously virtually unknown except in small circles of legal experts, became common vocabulary among corporate managers and the business press. Committees of corporate executives, investors, academics, and bureaucrats published a barrage of reports, proposals, and surveys, highlighting Japan's corporate governance crisis, and proposing solutions. There is room for debate over the degree to which inadequate corporate governance was to blame for the bubble economy and the scandals of the early 1990's. It is clear, however, tha