Thinking Points

  • Japan’s corporate governance, notoriously poor, actually functioned well once upon a time.
  • Many investors, particularly the foreign ones, have been hurt by the context-dependent understanding of corporate ownership and how it relates to governance in Japan.
  • Regardless, change is on the horizon, and investors ought to be excited about what lies ahead.

If you’ve spent more than a couple hours reading about Japanese equities, you’ve probably run into an article or three about Japan’s poor corporate governance. Though I agree that corporate governance in Japan needs some work, the topic is more nuanced than it initially appears. Understanding the development behind today’s system, combined with cultural context, ought to prove helpful in thinking about governance and how it relates to your investments.

Differing views on ownership

In last week’s article, Avoid T. Boone Pickens’ “Keiretsu” Mistake, I referenced a 1992 Chicago Tribune article written by T. Boone Pickens. The article is about the Keiretsu system and its cartel-like operations, which helped make Japanese automakers into a global force. In this article, Mr. Pickens described his Keiretsu experience:

“Three years ago I purchased a 26 percent interest in Koito Manufacturing, a large Japanese auto-parts maker. At the time, I knew little of the keiretsu system, but I saw an opportunity to profit and, at the same time, help the company move into the global marketplace. My goal as largest stockholder was to gain a seat on Koito`s board of directors. I naively thought it was a reasonable request, since Koito`s second-largest shareholder, Toyota Motor Co., was awarded three board seats for its 19 percent ownership stake. Wishful thinking on my part. Despite a 2 1/2-year effort, the Japanese denied what in American corporations is considered a right.

– T. Boone Pickens, Chicago Tribune (emphasis added by me)

I highlighted in bold what was particularly interesting to me. In American corporations, shareholders are the owners. It may seem odd to even point this fact out. But in Japan, the perception is that shareholders aren’t the only owners. Its stakeholders – suppliers, customers, neighborhoods, and employees especially – are “owners” too.

Take it from the Germans

German investors probably understand Japanese corporate governance better than American investors.

Why?

For starters, German employees have significant representation.

Germany’s two board system consists of the board of management, which handles day to day operations, and the supervisory board, which oversees the company’s board of management (and appoints its members).

For companies with 500 to 2,000 employees, employee representatives make up for one-third of the board. For companies with over 2,000 employees, half of the board consists of employee representatives. The chairman of the board is elected by the shareholders and the deputy chairman is selected by employee representatives. In the event of a tie vote, the chairman casts the deciding vote. This leans the Supervisory Board slightly toward shareholders. However, that’s a large amount of say going to employees for not actually owning the company.

This speaks to the value of a company in the broader societal context. With Japan sharing similar “societal context” views, the German approach to corporate governance is probably more relatable to the Japanese than the American approach. At the very least, it explains why Mr. Pickens wasn’t welcomed to the boardroom.

Japan’s case

Once upon a time, war torn Japan was struggling to get back on its feet. Stripped of effectively all of its assets, your average Japanese Joe needed to borrow to build and rebuild for the future. The loans, as you might imagine, came from banks. Because Japanese businesses were dependent on borrowings, executives paid frequent visits to their banks, nurturing a healthy business relationship. Banks, of course, needed to cover themselves too – making sure paper assets actually existed and that businesses were operating as described.

In addition to banks, the old Zaibatsus, or the modern day Keiretsus, served as a governing force too. Through interlocking business relationships and ownership, Keiretsu companies were governing one another. Typically organized with one head company and a main bank at the top of the hierarchy, Keiretsu companies were steered in the same general direction as the head company. This was done through cross shareholding and insertion of head company personnel into Keiretsu company management, among other methods. Just as T. Boone Pickens pointed out, these companies were in collusion with the government, too.

Eventually, as companies accrued more wealth, executives started paying fewer and fewer visits to banks. In fact, banks started visiting companies instead. The power balance had shifted. After years of profitability and a decent cash chest, the need for a loan, along with the value of a close bank relationship diminished for corporate Japan. The primary pillar of governance had lost its grip. Even the Keiretsu system, the second pillar of governance, was loosening up as companies started venturing out into other business areas.

This is more or less what Tatsuya Tamura, founder and special advisor of Japan Corporate Governance Network, wrote about in How Corporate Governance in Japan Should be Reformed (Japanese source) back in 2007.

Boone Pickens’ position in the hierarchy

The emergence of Keiretsus, where companies like Toyota Motors (TSE: 7203) sit at the top of the chain, developed interlocking business relationships down the supply chain. Though Mr. Pickens never mentioned the positives of the Keiretsu operations, supply chain concepts like Just-In-Time owes its birth to the Keiretsu system. Still, this left little room for foreign investors.

Cross-shareholdings became common to combat hostile takeovers, increasing predictability, control, and cooperation. Though Mr. Pickens had his 26% stake in Koito Manufacturing (TSE: 7276), his ownership value in the context of the broader system was considerably lower. In a different light, Keiretsus were organized to maximize economic efficiencies, and Toyota’s 19% stake in Koito, along with whatever other stakes (both hard and “soft”) it had in other companies in the system gave Toyota much more say in the boardroom than Mr. Pickens could’ve dreamed of. His exclusion was by design.

In this Keiretsu context, the Japanese board system made sense.

Governing the future

With Japan’s importance in today’s increasingly global world, the Japanese corporate governance system designed for the Japanese no longer makes sense. The Keiretsu governance of yesteryear ought to be replaced.

Regardless, what we see as Japan’s poor governance today is the culmination of what worked for decades on end. Clearly, a 26% stake with no board seat is unacceptable, and Mr. Pickens was rightfully frustrated. That said, for foreign investors looking into Japan, the focal point shouldn’t be on yesteryear’s governance, but on the lead measures of change. That is, the steps in place that lead to future change, and how viable these steps are.

Chris Vilburn, head of Goldman Sachs’ GS Sustain Japan wrote about these lead measures in his recent Nikkei Asian Review article:

“In the coming months, Japan is set to reach another important milestone in its path toward improving the business environment with the first set of revisions to the 2015 Corporate Governance Code. The changes — which focus on unwinding cross shareholdings, broader adoption of compensation and nomination committees, and greater diversity on boards — are important steps in moving Japan closer to global governance practices.”

– Chris Vilburn, Nikkei Asian Review

Cross shareholdings, an integral part of the Keiretsu system, is being driven toward change. If followed by leading Japanese companies, this ought to clear up a lot of the smoke and mirrors that Mr. Pickens walked into. The important part here isn’t so much about how quickly the change is or isn’t happening, but that there’s a push for it.

The bottom line

Japan’s notorious corporate governance system was a well-oiled machine once upon a time. As the country grew more relevant internationally, the system designed for the Japanese no longer made sense. This has caused heartache for foreign investors like T. Boone Pickens. With that said, change is on the horizon, and investors ought to be excited.

 

Author: Kenkyo Investing

Kenkyo Investing applies a value investing approach to Japanese equities, providing insights that are often unavailable to non-Japanese speakers.