The Influence of Institutional Investors on Corporate Governance and Firm Performance : Evidence from Japan

Using data of firms listed on the First Section of Tokyo Stock Exchange during FY2005-FY2010, we examine the influence of institutional investors on corporate governance and the relationship between institutional investors and firm performance in Japan. Institutional investors have become active in strengthening corporate governance with an eye of enhancing corporate value since the beginning of 2000s. They exercise the voting rights at the general shareholders’ meeting and some of them engage in dialogue with investee companies. The results of our analysis suggest that corporate governance was improved by institutional investors. It was also found that there is a statistically significant difference between the change in institutional investors’ shareholdings and firm performance during the analysis period. By dividing the firms into five groups from the viewpoint of the increase in the ownership share of institutional investors, we found that the mean value of ROE is higher in group 5, indicating that the group with the highest increase of institutional ownership during FY2005-FY2010 shows better performance than other groups. This indicates that institutional investors select firms for investment based on the expected performance of ROE and enhance value creation of investee firms by monitoring activity. keywords: institutional investors, corporate governance, firm performance Mitsuru Mizuno and Hajime Shimizu 76 Generally speaking, institutional investors have a tendency to invest in companies keen on improving governance structure. As such, the strength of governance might have an impact on funding activities of companies. International reputation for corporate governance of Japanese companies is not high because outside directors are not obliged (Asian Corporate Governance Association, 2008). International Corporate Governance Network (ICGN) approved a “Statement of Principles on Institutional Shareholder Responsibilities” in 2007. The Statement sets out the ICGN’s view on the responsibilities of institutional shareholders both in relation to their external role as owners of company equity, and also in relation to their internal governance. The Statement also claims that “Institutions that comply with the enlarged principles will have both a stronger claim to the trust of their end beneficiaries and to the exercising of the rights of equity ownership on their behalf. ” In Japan, there is an issue on improving the transparency of the exercise of voting rights at the shareholders’ meeting. Tokyo Stock Exchange (TSE) made a request in October 2009 to improve the transparency of the exercise of voting rights by publication of the results. In addition, TSE announced a policy that listed companies have to register at least one person as independent director and/or auditor either from outside directors or from statutory auditors unrelated to management by March 2010. The debate on corporate governance has become more active since the mid-1990s in Japan. The influence of the main bank was weakened by the collapse of the bubble economy in the early 1990s, while on the other hand, that of institutional investors, inter alia, foreign institutional investors, has become strong. Japanese companies had to respond to the demands of institutional investors with an increase in the incentives for executives and accelerated decision-making by introducing stock option plans and executive officer system as well as an increase in the dividend. Japanese corporate governance system has reached a major turning point in 2002. The companies were allowed to select a corporate structure, either US style committee-based or company auditor corporate structure by the revision of the Commercial Code. However, the percentage of companies that have selected the corporate structure with committees was only 2.6% as of December 2012 among the companies listed on the First Section of TSE. With the internationalization of corporate activities and global asset allocation of foreign investors, there is a need to develop governance structure which meet the requirements of institutional investors and enhance corporate value. In light of international trends, responding positively to strengthen corporate governance leads to the confidence of Japanese companies by institutional investors. It is believed that a positive impact on business activities would be felt, if capital markets are reactivated by brisk investment of institutional investors. This paper analyzes empirically the influence of institutional investors on corporate governance and firm value during the six years from FY 2005 and FY2010. The contributions of this paper are threefold. The first contribution is that corporate governance was actually improved by institutional investors. The second is that the paper employs a dynamic analysis of the changes of share ownership of institutional investors during FY2005-FY2010 for the examination of improvement of corporate governance and firm performance, instead of conventional static analysis which employs share ownership of institutional investors at a specific date. The third is to appreciate the investment behavior, inter alia, criteria on investment in and value creation of firms through monitoring activity by institutional investors in Japan. The study consists of six parts. In the following section, institutional investors and corporate governance is discussed. Section 3 reviews the preceding researches on corporate governance and institutional investors. In section 4, the research design and methodology employed in the study is explained. Section 5 presents the results and discussion. The last part concludes the study with general remarks. INSTITUTIONAL INVESTORS AND CORPORATE GOVERNANCE Japanese firms had been characterized by main bank system and cross-shareholdings up to the early 1990s. Morck and Nakamura (1999) pointed out that Japan’s main bank and financial keiretsu system left corporate governance largely in the The Influence of Institutional Investors on Corporate Governance and Firm Performance: Evidence from Japan The Institute for Creative Management and Innovation, Kinki University 77 hands of creditors rather than shareholders. The influence of the main bank on firms has declined in the wake of bubble burst in the beginning of 1990s, while the shareholders of firms, inter alia, institutional investors including foreign investors have begun to assume more importance in exerting an influence on firms (Mizuno, 2010). Of particular significance was a dramatic increase of foreign investors, majority of which are institutional investors, whose share rose from 7.7% in 1993 to 28% in 2006 (Table 1). On the other hand, with the exception of trust banks which include investment trust and pension funds, other financial institutions such as commercial banks, regional banks, life insurance, etc. decreased their ownership share. This increasing international ownership has a great impact on corporate governance in Japan (Ahmadjian 2007). The Japanese firms responded to the demand of institutional investors by adopting a system such as non-statutory executive officers and independent statutory auditors. Influenced apparently by foreign institutional investors, Japanese institutional investors have also kept an eye on corporate governance. The Pension Fund Association (PFA) of Japan has taken an initiative in adopting the corporate governance guideline and has exercised their voting rights based on the guideline. Table 2 shows the results of exercise of shareholder voting rights of PFA portfolio companies in June 2010. PFA voted to oppose or abstained from voting in 487 company proposals, with an opposing vote ratio of 18.1%, which increased from 12.4% compared to the previous year. The increase in the ratio of votes against company proposals is partly attributed to a considerable decline in the number of proposals regarding partial amendments to articles of incorporation from 828 in 2009 to 167 in 2010, in which PFA generally voted in favor, resulting in the overall higher vote ratio against the proposals, and partly to a higher vote ratio against the proposals such as appropriations of retained earnings and revisions of executive remuneration. The ratio of votes against proposals on the payment of retirement allowances to directors and corporate auditors increased to 25.8% in June 2010 from 22.0% in the previous year. Likewise, the ratio of votes against proposals on granting stock options increased to 14.1% from 11.1% compared to the previous year. The PFA opposes granting stock options in cases where it does not lead to the improvement of earnings performance. The overall results indicate that companies have to make efforts to further improve corporate governance to meet the requirements of PFA. Table 1: Trend of ownership by type of investors Fiscal Year Financial