The Evenlode Global Income team selected Japan as its target for a geographical deep dive in 2024. The key themes discussed were:
- History of the Japanese economy.
- Accounting, reporting and corporate access.
- Review of new ideas.
- Corporate governance reforms.
Having visited the country in 2019 to research companies and the corporate governance landscape, we felt enough time had passed to revisit some of the questions raised during that trip. Interest in the equity market picked up last year driven by a weaker yen, improved transparency through new rules introduced by the Tokyo Stock Exchange, and the Topix surpassing highs not seen in over thirty years.
Despite some of the governance and reporting challenges, we have already invested client capital in a small number of Japanese companies where the business models are readily visible to us. And while some challenges remain, progress on the key issues of corporate governance and reporting has been made. There is push back on the notion that the Kansayaku (see page 29) board structure is as weak as is made out in the West, and diversity on boards has improved. The analysis of executive compensation clarified the pros and cons of corporate culture in Japan. On the one hand it is commendable that executives put the success of the corporation over individual wealth accumulation. But on the other, Japanese companies may benefit from the experience brought by managers of overseas enterprises in a globally integrated and competitive market. That experience would come with an elevated benchmark for individual remuneration.
An analysis of accounting scandals highlighted some of the challenges that Japanese corporate culture may bring to businesses, particularly firms experiencing operational or competitive disruption. This made us think that we should certainly not let our analytical guard down in our financial analysis of Japanese businesses. We have the guard firmly up for Western companies for good reason – a different culture has not resulted in zero scandals or corporate collapses. Corporate reporting and access remain a challenge, however, with large corporations reporting in English there is at least an opportunity to hear or read the company’s view of itself in a language we can understand. We discussed the history, corporate access and reviewed various new ideas in our deep dive, however we have highlighted the important reforms in corporate governance below.
Corporate governance reforms
The Japanese Corporate Governance Code defines corporate governance as a structure for transparent, fair, timely and decisive decision-making by companies, not forgetting the needs and perspectives of shareholders, customers, employees and local communities. It was a significant milestone in the country’s efforts to modernise its corporate governance practices. Although the definition and the desired outcome of the Code sounds like the western multistakeholder approach, the governance system is markedly different (lagging) to many western models.
Since the financial crisis in the 1990s and the establishment of the Corporate Governance Code in 2015, changes have aimed to enhance transparency and accountability with the ultimate objective being the growth of the Japanese economy.
Japan’s corporate governance reforms have focused on three primary objectives:
- Strengthening management systems and group governance
One of the most notable changes has been the push for gender diversity on corporate boards. In June 2023, the Japanese government set a goal for women to account for over 30% of directors on Tokyo Stock Exchange Prime Market companies by 2030. Progress has been made; in 2013, 84% of listed companies had no female board members, but by 2022, that number had dropped to 19%.
2. Enhancing shareholder engagement
Japan has embraced digital transformation to increase corporate transparency and engagement. New technologies such as e-voting, e-disclosure, and e-meetings have improved shareholder participation. The Ministry of Economy, Trade, and Industry (METI) has promoted Digital Governance as a framework to enhance corporate value while addressing cybersecurity and balancing innovation with traditional business culture.
3. Promoting medium- to long-term investment
‘Guidelines for Investor and Company Engagement’ have encouraged a ‘comply or explain’ approach, ensuring companies actively engage with shareholders and integrate long-term investment strategies. These efforts align with the broader goal of improving return on equity (ROE) and return on assets (ROA), which have historically been lower in Japan than in western economies.
Kansayaku Board System
Japan offers three corporate governance structures:
- The Kansayaku Board (Audit and Supervisory Board).
- Companies with three designated committees (Nomination, Remuneration, and Audit).
- Companies with an Audit and Supervisory Committee.
The Kansayaku Board remains the most common governance structure in Japan, though it is often met with scepticism by foreign investors. Established over 130 years ago, it primarily oversees management and audits accounting practices. The main responsibilities of the Kansayaku Board are auditing financial statements, preventing fraud and even conducting investigations with the authority to sue directors. Although the latter can prove to be a big advantage, paradoxically, in one way this is also a weakness of the system, as the powers are so strong and confrontational in nature, that they are almost never exercised. The Kansayaku board also has a legal authority to prevent management fraud, often seen as more critical than the roles played by independent directors in other governance models. However, they have weaker powers compared to audit committees as they are not full board members with voting rights, which limits their ability to influence board decisions directly.
Keiretsu
This is a Japanese term referring to a network of interrelated businesses with cross-ownership, usually centred around a large financial institution or conglomerate. Strategically, it is an approach where companies invest in each other to develop a reciprocal ownership arrangement. The system helps insulate each company from stock market fluctuations and takeover attempts.
The Keiretsu can be categorised by two types:
- Horizontal: an alliance of cross-shareholding companies led by a Japanese bank that provides the necessary financial services. Historically, horizontal structure was more dominant, however, due to significant reduction in cross-shareholding practices and the 1990s economic crisis which led to Japanese banks losing their dominant position, the structure has been in decline.
- Vertical: a partnership of manufacturers, suppliers, and distributors that work cooperatively to increase efficiencies and reduce costs. This has become more dominant in contemporary Japan especially in the automotive and electronics industry. This structure allows for tighter integration of supply chains, which is crucial in the current economic environment as it enables companies to maintain better control over quality and costs.
Remuneration
Disclosure
Despite efforts to enhance transparency, progress in improving disclosure on remuneration has been slow. Companies are still only required to disclose the pay of executives earning ¥100m (£520,000) or more. This regulation has been in place since 2010. Listed companies in Japan typically pay independent directors a fixed monthly fee rather than stock options. While some offer restricted stock, these instances are usually tightly structured and transparent.
Quantum
Japanese executives traditionally earn a fraction of what their US and European counterparts receive. This can be challenging for Japanese companies operating overseas, acquiring overseas firms or trying to attract new overseas talent. For CEOs of very large corporations earning over $10 billion in annual revenues, the average compensation package – including fixed salary, performance-based pay, and stock options – is approximately $10m in the US, $6m in Europe, but only slightly over $1m in Japan. This disparity highlights a cultural difference in Japan, where the success of the corporation often takes precedence over individual wealth accumulation.
While cultural differences in wealth accumulation exist, there is a significant gap between the salaries of Japanese and US companies. This could pose challenges for Japanese companies in attracting talent. For example, in 2022, the average CEO compensation at Japan’s top 100 companies was about $1.5m, compared to around $14.7m for CEOs of S&P 500 companies in the US. Some Japanese companies are beginning to adopt more performance-based pay systems and increasing executive compensation to better compete globally, however, there is still a significant hurdle for Japan’s economic competitiveness in sectors such as technology and engineering.
Conclusion
Japan’s corporate governance reforms, while significant, have faced challenges in fully aligning with western models, particularly those emphasising shareholders. The Kansayaku Board, a unique Japanese governance framework, offers some power and oversight advantages, but comes with limitations around independence and influence. The Keiretsu, a network of interrelated businesses, has historically provided stability but the horizontal structural has created inefficiencies. However, the move towards a vertical structure enables companies to maintain better control over quality, costs, and production timelines.
Despite progress in areas like gender diversity and digitisation, the country’s remuneration practices and disclosure standards still lag international standards. The slow pace of reform, coupled with cultural factors and the enduring influence of traditional business structures, highlights the complexities of modernising Japan’s corporate governance landscape, although whether the western style of corporate governance is the right approach remains debatable.
The Evenlode Global Income team
2024
Please note, these views represent the opinions of the Evenlode Team as of 2024 and do not constitute investment advice. Where opinions are expressed, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice. This document is not intended as a recommendation to invest in any particular asset class, security or strategy. The information provided is for illustrative purposes only and should not be relied upon as a recommendation to buy or sell securities. Every effort is taken to ensure the accuracy of the data in this document, but no warranties are given.