Has Japan’s corporate governance reform reached a turning point? Some cautionary notes

ABSTRACT

Japan has identified corporate governance as an important element in its attempt to reform its economic system. A combination of political will and sustained implementation by civil servants has produced a corporate governance code and associated mechanisms to sustain and refine the changes that have been introduced in order to raise corporate profitability and stimulate the whole national economy. Meanwhile, the direction of reform has shifted from an initially principles-based approach towards an increasingly proscriptive, rules-based one, favouring the interests of investors over those of other stakeholders. Whether this will achieve the desired results is increasingly being questioned within Japan and runs counter to experience from markets where shareholder primacy already prevails. Japan’s own prior experience of trying to transplant laws and institutions from these markets suggests a need for caution.

KEYWORDS:

• Corporate governance
• Japan
• principles-based approach
• reform
• rules-based approach
• shareholder primacy

Introduction

Since 2013 Japan has made a major and sustained effort to revitalize and even reconstruct its corporate governance. Political will has imposed initial reform and created an enduring mechanism to review and adjust the resulting framework thereafter. At the core of this effort is a code of conduct for corporate governance, supported by a complementary code for investors. The tone of reform initially borrowed heavily from the UK experience, incorporating the concept of comply or explain initiated by the Cadbury Report to bring flexibility, and relying on investor pressure to improve corporate responses. Subsequently it has veered further towards the explicitly shareholder-favouring ideas that have characterized the US, the UK, and other markets influenced by agency theory and the interests of institutional investors, diverging from a principles-based approach towards greater reliance on prescription. After proceeding at a remarkable pace for ten years, the outward appearance of radical reform is striking. However, the degree to which these outward changes are influencing the practical behaviour of managers, and whether they are producing the national economic revival that was originally declared to be their ultimate objective, is less clear. The debate underpinning the next review exercise, originally expected for spring 2024 under the timetable observed hitherto but now likely to be delayed (Daiwa Sōken 2023), has revealed uncertainties that need to be addressed.

Political support for the reform initiative

A distinguishing feature of recent efforts to reform Japanese corporate governance is the strength of political support. Soon after its return to power in 2012, the Liberal Democratic Party (LDP) established its Japan Economic Revival Headquarters (hereafter ‘JERH’), publishing a Japan Revitalization Strategy in 2013 which listed corporate governance reform among its eight areas of concern and proposed amendments to the Companies Act designed, among other concerns, to strengthen the role of external or ‘outside’ directors. In 2014 the JERH published a Japan Revitalization Vision which contained detailed proposals for a corporate governance code and in the same year a revised Revitalization Strategy confirmed that this would be drafted. Meanwhile the prime minister, Abe Shinzō, had explicitly included corporate governance in his ‘Abenomics’ programme as part of the structural reforms needed to achieve economic revival (see, for example, Miyajima and Saitō 2020). The combination of Abe’s enthusiasm for corporate governance at a strategic level and the diligence of other LDP politicians who progressed the detailed process of reform through the civil service and expert committees led to a series of related developments in 2014 and 2015, beginning with the Stewardship Code and the Itō Review in 2014, followed by the Corporate Governance Code in 2015. In 2017 a further element was introduced when the JERH’s Future Investment Strategy announced the Council of Experts Concerning the Follow-up of Japan’s Stewardship Code and Japan’s Corporate Governance Code（hereafter the ‘Follow-up Committee’) to oversee periodically the development of the Stewardship and Corporate Governance Codes. Through this rapid progression of reforms the LDP succeeded in establishing a seemingly robust system to influence, monitor and adjust corporate governance practices.

This achievement contrasts with the general lack of progress that preceded it, where promotion of optional new corporate structures, admonitions, and guidelines had mostly failed to produce radical change. Dissatisfaction with Japan’s post-war corporate governance regime, with its emphasis on the interests of the company and those stakeholders seen as directly contributing to its success, grew during the 1990s, after the bursting of the equity and real estate ‘Bubble’, but did not deliver immediately transformative change. Attention focused on US governance practices, on the assumption that they were driving the US’s contemporary economic success, but this enthusiasm was initially restricted to theoretical debate. The first practical change came in 1997, when Sony reduced its board of directors and created a new role of executive officer, effectively focusing its newly reduced board on supervisory duties and delegating control of daily operations to its new executive officers, most of whom would formerly have served as junior directors contributing to the board’s overpopulation and unwieldiness as a forum for debate. This reform was widely copied, though perhaps more for practical reasons than from any doctrinaire desire to split supervision and execution (Dore 2000). For example, it addressed the problem of excessively large boards that had become commonplace where board membership was seen as a final reward for loyal service. In 1998 the Japan Corporate Governance Forum (since 2012 part of the Japan Corporate Governance Network and not to be confused with the official body of the same name established in 2022, discussed below) issued its Corporate Governance Principles, calling for more accountability to shareholders, transparency, differentiation between supervision and execution, and a majority of non-executives on boards. In 2002 the internal auditor (kansayaku) system was strengthened to increase external membership, a reform which has probably raised the quality of supervision but was seen at the time as an attempt by traditionalists to reinforce the existing system at the expense of more radical reform. Soon afterwards, in 2003, the Company with Committees, with three independent committees, each comprising a majority of outside directors, to handle audit, nomination and remuneration, was introduced as an optional alternative to the existing corporate structure overseen by kansayaku. This was envisaged by reformers as a platform to introduce the enlightened corporate governance in the US style that many of them favoured but opposition from corporate interests, expressed through the Keidanren (Japan Business Federation), ensured that it became only an optional structure and adoption proved limited (Imai 2001; JCAA 2009). In 2004 the Listed Company Governance Committee assembled by the Tōkyō Stock Exchange (TSE) issued its Principles of Corporate Governance for Listed Companies, which called for more effective governance within the existing framework. Yet, despite all these initiatives, and a general feeling shared by many civil servants, academics, investors, and some corporate managers that change was needed to repair an inadequate system, the state of corporate governance at most Japanese companies around 2010 was not markedly different from that in 1990 (see, for example, Nakamura 2016).

The LDP has managed to change this situation, partly because it focused on a corporate governance code enforced through the TSE and thereby linked to listed status, and partly because it established a robust mechanism under the Financial Services Agency (FSA) to review the continuing state of governance and initiate change. Under Kishida Fumio’s government, political support has been maintained. At his speech to the New York Stock Exchange in September 2022, Kishida drew special attention to corporate governance reform as an indication of Japan’s increased attraction as an investment target: ‘One very important policy is corporate governance reform … We will accelerate and further strengthen corporate governance reforms in Japan … ’ (Kishida 2022). Thus a supervisory structure has been created and momentum achieved, with every appearance of continuing political will to sustain it. Let us now consider the nature of this structure and where its reform efforts seem to be leading.

The first initiative 2014–15

The mechanism created by LDP politicians to drive corporate governance reform is presided over by the FSA in collaboration with the TSE and operates formally through the Follow-up Committee of experts (described above) whose members debate and define reform proposals. The choice of the FSA to oversee this process, rather that the Ministry of Economy, Trade and Industry (METI), is a departure from the traditional division of responsibilities among the ministries. METI regulates economic affairs and would seem the logical choice to reform the governance of Japanese companies; it has its own advisory committee, the Corporate Governance System Study Group (the ‘CGS Study Group’), which continues to issue periodic guidelines on corporate governance practice. Nevertheless, an LDP politician involved in the preparations that led to the first Corporate Governance Code of 2015 commented that the FSA was chosen because it was the financial regulator (which oversees the TSE, among other responsibilities) and also precisely because it was considered to be less enmeshed with corporate interests.

Japan’s first Corporate Governance Code, issued in March 2015, was the core of the reform exercise but it was preceded by Japan’s first Stewardship Code, in February 2014 and the Itō Review in August 2014. While this sequence of timing may have been intentional, it was suggested by an officer of the FSA in early 2017 that the need to coordinate the Corporate Governance Code with amendments to the Companies Law delayed its finalization, whereas the other initiatives were able to proceed at their own pace. The Stewardship Code, closely modelled on the UK Stewardship Code, was described as a compliment to the Corporate Governance Code with the two codes depicted as ‘the two wheels of a cart’; it was an explicit call for institutional investors to exercise responsible stewardship towards the companies in which they invested, in much the same way that the UK’s Cadbury Report had seen investors as the natural invigilators of sound corporate governance (Cadbury 1992). The Itō Review is a related but separate exercise, organized by METI rather than by the FSA, and drawing inspiration from the UK’s Kay Review of 2011, which examined the role of equity markets in the UK and questioned whether they were promoting good corporate governance to sustain long-term profitability and whether short-termism was undermining this effort. The Itō Review undertook a similarly broad examination of investors’ interactions with companies in the face of persistently low returns from Japanese equities but in practice it attracted attention for its premise that Japanese companies’ generally low return on equity (ROE) was caused primarily by low profitability and for its recommended target of minimum 8% ROE.

The Corporate Governance Code was published in March 2015 (the ‘2015 Code’) against this background. It differed from previous admonitions for improved governance in several important ways. As explained, it was associated with the Stewardship Code, in the hope that investor pressure would ensure a satisfactory response from companies. It was based on principles rather than rules and gave the option either to comply or explain reasons for non-compliance. Its purpose was declared to be the promotion of medium- to long-term corporate growth, thereby contributing to national economic revival. Finally, and most importantly, it was overseen by the FSA and implemented through the TSE, positioning it as part of listing requirements, and a regime was established to review it periodically. This was clearly a reform that amounted to more than mere guidelines and it could not be ignored by any company that valued listed status. The new code was generally well received by corporate managements because it focused on concepts of best practice that were already widely understood and did not attempt to sweep away existing ideas of how governance should be handled. One practical advantage that it enjoyed over previous initiatives was that corporate administrators charged with compliance matters (usually general affairs departments) now had to deal with a body of explicit requirements linked to their companies’ listings for which they had either to comply or explain non-compliance, channelling them into a familiar pattern of analysing the requirements against their existing practice, summarizing implied changes, and making recommendations to senior management, which ensured that boards were fully aware of the new Code and its implications for their governance (Buchanan, Chai, and Deakin 2019).

Subsequent developments 2018–21

In June 2018 the first revision to the Code was published (the ‘2018 Revision’). In contrast to the 2015 Code, a more didactic tone was apparent, moving beyond general principles to recommend specific actions in key areas of governance: reduction of cross shareholdings, CEO succession planning, independent nomination and remuneration committees, board diversity, disclosure of business strategies, and cost of capital awareness. Compliance levels fell in all of these areas, suggesting that many companies found difficulty in complying (see Buchanan 2022). The next revision was published in 2021 (the ‘2021 Revision’). Didacticism increased and became explicit prescription in many areas. The 2021 Revision was moreover linked to qualification for the TSE’s new Prime Market, which opened in April 2022, effectively making compliance mandatory for companies with ambitions to be listed there; in theory companies seeking Prime Market listings could still opt not to comply, offering explanations instead for non-compliance with any of the Code’s articles, but few seem to have done so. The next revision was expected in 2024, although there is now uncertainty regarding the exact timing. It is likely to be informed by findings from the new Japan Corporate Governance Forum (JCGF) which Kishida mentioned in his September 2022 speech in New York as part of Japan’s continuing corporate governance initiative. This body was duly established by the FSA and had conducted six forum meetings with investment bodies as of June 2023.

The development of the Corporate Governance Code from 2015 to 2021 suggests the direction of travel that the FSA and its advisers appear to favour; the declared objectives and methodology of the 2015 Code seem to have been superseded. The objectives of the codification exercise were stated in the introduction to the 2015 Code as follows: This Corporate Governance Code establishes fundamental principles for effective corporate governance at listed companies in Japan. It is expected that the Code’s appropriate implementation will contribute to the development and success of companies, investors and the Japanese economy as a whole through individual companies self-motivated actions so as to achieve sustainable growth and increase corporate value over the mid- to long-term’. It implies that corporate success and national economic revival are major objectives and that corporate initiatives appropriate to individual companies’ circumstances should be the drivers of reform. The same text was repeated unmodified in the introductions to both the 2018 and 2021 Revisions. In explanation of its methodology, the 2015 Code emphasized that ‘the Code does not adopt a rule-based approach, in which the actions to be taken by companies are specified in detail. Rather, it adopts a principles-based approach so as to achieve effective corporate governance in accordance with each company’s particular situation’. Moreover ‘It is necessary to bear fully in mind that companies subject to the Code are not required to comply with all of its principles uniformly’. However, the growing didacticism evident from the 2018 Revision appears to contradict these statements and the 2021 Revision, by linking many new or amended requirements to the Prime Market, effectively moves in many instances to a rules-based formula where complying companies have to adopt specific practices and demonstrate that they have done so. Notable among these are disclosure of policies and measurable goals for personnel diversity, disclosure of sustainability goals linked to the standards of external organizations such as the TCFD, raising the proportion of independent non-executive directors to at least one third of board membership, establishing independent nomination and remuneration committees, and disclosing the nomination process for directors, together with a ‘skills matrix’ statement. Most of these requirements are linked to the Prime Market, but the hope was expressed that companies listed on other markets would be encouraged to follow similar practices. None of these requirements seem detrimental to good corporate governance but the very fact that they are requirements threatens to undermine the whole concept of principles-based corporate governance. The tenor of the Corporate Governance Code appears to be shifting to a rules-based approach in which the FSA and its advisers decide how companies should be governed and decree appropriately.

Another important aspect of these developments is the apparent tilt towards shareholder primacy and prioritization of the interests of investors in general. The 2015 Code made clear that shareholders were an important constituency when it expressed the hope that its implementation would ‘contribute to the development of companies, investors and the Japanese economy as a whole’. But at this stage the emphasis on benefit to companies and to the national economy still seemed strong. With hindsight, the choice of the FSA, acting through the TSE, rather than METI, to oversee the reform process hints at especial concern for investors’ interests but the flexibility and pragmatism of the 2015 Code tended to draw attention away from this aspect. But by the time of the 2021 Revision elements that seem designed to please investors were increasingly salient. Transparency and supervision by outside directors are the keynotes of this Revision, expressed in increasingly intrusive and explicit terms that require companies to observe certain practices and demonstrate their compliance. In theory companies may also explain their non-compliance but the link to Prime Market requirements makes this a difficult choice for any but the most determined of boards. If corporate governance is seen as a mechanism to protect investors’ interests and ensure appropriate treatment of shareholders, then this approach is understandable. Dore observed the spread of these ideas globally in 2008: ‘Increasing efforts on the part of government to promote an “equity culture” in the belief that it will enhance the ability of its own nationals to compete internationally’ (Dore 2008). This idea has certainly become an accepted orthodoxy for many academics and practitioners in markets that favour shareholder primacy, such as the US or the UK, but it runs counter to the intuitive viewpoint of most Japanese managers who see the company as the focus of concern (see, for example, Nikkaku 2021). If corporate governance is seen as the set of mechanisms by which boards administer companies to ensure long-term success for the business while generating prosperity equitably for all stakeholders, as implied by the 2015 Code, then this is a major divergence in favour of a single stakeholder group.

Success of the reforms to date

As explained above, the forms of Japanese corporate governance have been changed and there is now an increasing tendency to demand adherence to the exact formats that regulators and their expert advisers consider appropriate. However, formal change does not necessarily alter the way that governance is actually carried out within companies and opinion appears to be divided as to whether the reforms are contributing to improved corporate performance, with the majority view being that they are not. Research has focused particularly on increases to the numbers of outside directors, as promoted by the Corporate Governance Code.

Ishida and Kōchiyama studied how Japanese companies increased the number of their outside directors to comply with the corporate governance reforms during the period 2015–2017 and noted a pronounced tendency to repurpose external kansayaku as outside directors, often shifting from an audit board to a company with audit committee structure at the same time: ‘Overall our findings suggest that the Japanese reforms increased the unnatural selection of outside directors and had a limited impact on changing the substance of the corporate governance system’ (Ishida and Kōchiyama 2022). From this evidence, one wonders how many other aspects of the reforms have been finessed by Japanese companies to permit them to continue with familiar practices.

Some researchers have concluded that the reforms, particularly with regard to the increased numbers of outside directors, have improved corporate performance: ‘Our study shows that increasing the participation of independent members in supervisory boards has had a positive impact on the performance of Japanese companies measured by corporate profitability, asset productivity, dividend payouts, acquisitions’ value, and valuation multiples’ (Mielcarz, Osiichuk, and Pulawska 2021) but the authors also note that these improvements in performance may be at the expense of job security for the workforce.

Other studies have reached less favourable conclusions. Miyajima observes: ‘According to my joint study with Keio University Associate Professor Takuji Saito, although the ROE rose during the period of the Abe administration, the degree to which the corporate governance reform uniquely contributed is negligible … the only clear change was an increase in returns to shareholders, including dividends and share repurchases’ (Miyajima 2021). Yanagida reports a similar result in his study on the effects of increasing the numbers of outside directors at Japanese companies during the period 2014–5: ‘I find no evidence that an increase in the number of outside directors significantly affects future performance’ (Yanagida 2022). Mitsudome makes a subtle distinction in his analysis: ‘ … I find that the percentages of outside directors on the boards are positively associated with annual stock returns, but not with the returns on assets or Tobin’s Q. This suggests that shareholders view increases in the presence of outside directors as a positive sign since it would mean better oversight over the management, but the outside directors may not directly contribute to the profitability or the increases in the market values relative to the book values of the net assets’ (Mitsudome 2023).

Thus the reforms appear to be influencing corporate behaviour in a direction that satisfies shareholders, through increased distribution of profits and improved transparency, but the majority of observers see little evidence so far of contribution to corporate profitability or national economic revival. From the narrow viewpoint of shareholder primacy, these reforms may be judged a success but their effect on the fundamental efficiency of companies is, at best, unclear. Moreover, as Ishida and Kōchiyama’s research indicates, there are doubts as to how effectively some of the reforms are really being implemented within companies.

The tenor of future revisions

Having established the mechanisms of corporate governance reform, the LDP is no longer evident in the operation and development of those mechanisms. These aspects are controlled by the FSA, working with the TSE, and the process of reviewing and debating the issues that comprise and surround corporate governance, feeding into periodic revisions of both the Corporate Governance Code and the Stewardship Code, are nominally entrusted to the Follow-up Committee. A further element was introduced in 2022 through the JCGF, described above, which invites opinions on corporate governance issues and holds meetings with investor groups, presumably advising its findings to the Follow-up Committee. METI’s contributions through its CGS Study Group are not directly linked to the FSA’s processes, but the Follow-up Committee and the CGS Study Group have some common members so it seems likely that there is at least an unofficial flow of ideas from METI’s proposals into the FSA’s debates.

Outwardly, the review mechanism based around the Follow-up Committee seems to be dominated by investor interests. Roughly 24% of the committee were from corporate backgrounds as of 19 April 2023, whereas investors, academics, and advisers (including a lawyer) each made up approximately the same percentage, effectively outnumbering commercial interests by three to one (Follow-up Committee 2023b). Moreover the aim of the JCGF, as described by Kishida and reiterated by the FSA, is to ‘hear from investors from around the world’ implying a bias in favour of the interests of institutional investors. Nevertheless, the reality may be more nuanced. The Follow-up Committee’s Action Program for Accelerating Corporate Governance Reform: From Form to Substance, published on 26 April 2023 shows the likely tenor of future developments. The document lists three groups of current issues for consideration:

1. Management issues, such as encouraging the management with an awareness of profit-making and growth based on the cost of capital and promoting initiatives relating to sustainability, including investment in human capital;

2. Issues related to the effectiveness of independent directors, such as improving the effectiveness of the board, the nomination committee and the remuneration committee, and improving the quality of independent directors; and

3. Issues related to dialogues between companies and investors, such as enhancement of information disclosure as well as dealing with legal issues, and market environment issues (Follow-up Committee 2023a).

Of these current issues, (1) and (2) above suggest continued attention to internal aspects of corporate governance and imply increasingly invasive measures to ensure compliance with the model of governance that the experts favour. It is possible to see (3) in the same way but the references to legal and market environment issues may equally refer to concerns raised by the Keidanren on behalf of its member companies, as described below. Two recent opinions submitted to the Follow-up Committee, from investor and corporate interests, respectively, illustrate the dynamics of this situation. An opinion dated 19 April 2023 from the International Corporate Governance Network (ICGN), whose CEO is a Follow-up Committee member, expresses general satisfaction with the direction of travel, summarily dismisses concerns expressed to the Committee that corporate governance reforms hitherto have not demonstrated any effect on corporate performance, and calls for stronger action in areas such as disclosure and the reduction of strategic shareholdings (ICGN 2023). This is essentially what might be expected from an investors’ advocacy organization such as ICGN and can be interpreted as an encouragement to greater prescription and regulation. However, an opinion submitted on the same date by Committee member Matsuoka Naomi (who is Chair of the Sub-Committee on Capital Markets at the Keidanren’s Committee on Financial and Capital Markets and is thus assumed to be transmitting the views of the Keidanren) draws attention to a number of points that appear to be causing concern among Japanese corporate managements, stating, ‘the corporate governance reform that is needed today is not to set detailed rules in the Corporate Governance Code (Governance Code), but rather to increase the effectiveness and substance of the reforms already in place, and to support steps taken by companies based on their own initiatives to improve mid- to long-term profitability and productivity’. The opinion moreover emphasizes that ‘we want to reemphasize the importance of adhering to the principles based approach and the comply-or-explain approach of the Governance Code’. Further comments deal with points such as the need for companies to avoid short-sighted policies to improve balance sheet ratios and the need to permit flexibility in sustainability compliance. The latter part of the document calls for improvements in investor behaviour through allocation of better resources to stewardship activities, more careful investigation by proxy advisers before they issue potentially influential guidance to investors, and the need for companies legally to be able to identify their ultimate shareholders (Keidanren 2023). None of these three latter points seems likely to enthuse investors who see corporate governance primarily as a tool to sustain shareholder primacy but perhaps most of interest is the Keidanren’s clear focus in its initial comments on the need to reduce prescriptive rules, to return the initiative to companies to determine their best choices, and to adhere to the principle-based approach of comply or explain; this appears to be a call for reversion to the spirit of the 2015 Code while reducing the didacticism and prescription increasingly evident since the 2018 Review.

The Keidanren’s concerns appear to have entered the debate concerning future policies and this suggests that the Follow-up Committee is not wholly focused on shareholder primacy and investors’ interests. The Action Program appears to be reflecting at least some of these concerns when it states: ‘It is vital to move the focus of reform from form to substance in resolving the above issues. Sufficient results cannot be expected only by satisfying form. Substance matters. Furthermore, it has been pointed out that further detailed requirements, if introduced, may undermine the original purpose of the “comply or explain” approach and may cause corporate governance reform in practice to lose its substance. Thus, it is desirable that effective solutions to individual companies’ corporate governance problems be considered in the context of reality, by identifying individual issues through constructive dialogues between companies and investors. It is also important for self-motivated changes to take place in the mindsets of companies and investors. To this end, it is necessary to create an environment that promotes such changes, as well as to make the dialogues between companies and investors more productive and more effective’. Interestingly, the Action Program also hints that revisions to the codes may not continue to follow the triannual cycle observed hitherto, implying a more pragmatic response to specific issues. A similar trend is evident also in a recent Nikkei editorial which notes the decision by the UK’s FRC to withdraw certain intrusive amendments that were planned for the UK corporate governance code and makes the following observation regarding developments in Japan: ‘Japan’s governance code, through a series of amendments, has progressively raised the hurdles regarding board composition. This has resulted in greater management transparency but, at the same time, one cannot overlook the ill-effects of formalism with regard to aspects such as the increase in outside directors whose specialist knowledge is questionable’ (Nihon Keizai Shimbun ‘Nikkei’ 13 December 2023).

Japanese corporate governance reform in comparative perspective

Japan’s corporate governance reforms have not been taking place in isolation from developments in other countries. To a large extent they are intended to replicate or mimic a model of shareholder-orientated corporate governance which is associated with American and, to a lesser extent, British practice. Strengthening shareholders’ rights to hold managers to account should, in theory, reduce agency costs and so drive down the cost of capital, thereby fuelling innovation and growth. ‘Radical’ innovation of the kind associated with Silicon Valley is sometimes attributed to the willingness of shareholders to assert their influence over corporate decision making (Summers 2001), and the designers of Abenomics appear to have expected some kind of similar outcome in Japan. So far, however, there is little or no sign of this happening (Miyajima and Saitō 2020). To see why it is helpful to put the Japanese reform programme in the context of wider trends in corporate law and regulation, and to consider the state of the art in the empirical literature on the economic and social effects of shareholder protection laws.

A first point to note, which may seem surprising in the light of the current Japanese debate but is well established empirically, is that Japan’s corporate laws are by no means among the weakest when it comes to shareholder rights. In fact, just the opposite, as we can see from Figure 1. At the beginning of the 1990s Japan had some of the most pro-shareholder laws in the world, comparable to those in the US and UK and significantly stronger than those in force, for example, in China and Germany at this point. Japan’s proximity to the US should not occasion any surprise when it is borne in mind that while Japan has a civil law system which was modelled on the German civil code as part of Meiji era modernization at the end of the nineteenth century, Japan’s corporate laws derive from a US model which was put in place during the period of the American occupation, post-World War Two, with only minor subsequent amendments (West 2001). On paper, at least, Japanese shareholders enjoy similar legal rights to those of their American and British counterparts when it comes to such matters as electing directors and preventing the dilution of voting and dividend rights.

Figure 1. Shareholder protection over time in selected countries.

Note: the vertical axis measures the extent of shareholder protection set out in corporate law and corporate governance standards as measured by the CBR Extended Shareholder Protection Index (SPI), with a higher score indicating more protection. The SPI is a composite of ten indicators measuring different aspects of legal and regulatory shareholder protection. See Deakin et al. (2018) for further details.

There are certain differences between Japan, on the one hand, and the US and UK, on the other, when it comes to the governance of takeover bids. During the 1980s and 1990s, hostile takeovers in the US and UK proved to be a highly effective means, on the one hand, of empowering shareholders in their relations and dealing with boards, and, on the other, of releasing reserves which would otherwise be tied up as retained earnings on corporate balance sheets (Armour and Skeel 2005). Since the 2000s, takeover bids or the threat of them have been frequently used by activist hedge funds in America and Britain in an attempt to induce target companies to declare increased dividends or initiate share buybacks. When this tactic was tried in Japan in the same period, however, it largely failed to bring about the expected corporate restructurings (Buchanan, Chai, and Deakin 2012). This was in part because the Japanese courts gave target boards greater leeway to adopt and trigger defensive measures including ‘poison pills’ which would have the effect of deterring bids by making them infeasibly expensive. In litigation around the Livedoor (2005) and Bull-Dog Sauce (2007) cases, Japanese judges took a sceptical view of takeovers, in some instances characterizing bidders as ‘abusive’ where they had no strategic plan for the company, other than breaking it up through asset disposals (Hayakawa and Whittaker 2009). This was not the sort of language that a judge in the Delaware Court of Chancery would ever have used, and while poison pills may in theory be triggered in the context of a US takeover, it seems that this has never actually happened there, contrary to the situation in Japan, where poison pills were widely adopted in the aftermath of the Bull-Dog Sauce ruling and were used to deter unwelcome approaches (Milhaupt 2009).

Until recently, the concrete reality of the Japanese poison pill as a real defence to a takeover bid was clear a point of difference to its largely symbolic status in US law and practice. UK practice was even more clearly against the poison pill, with its Takeover Code more or less explicitly ruling out this kind of ex ante defence (Armour and Skeel 2005). There are, however, some signs that the Japanese courts are shifting their position on poison pills. Although in 2021 the Japanese Supreme Court affirmed, in the Tōkyō Kikai case, a poison pill which had operated as an anti-takeover device, a subsequent decision, Mitsuboshi, saw the Court strike down an anti-activist poison pill on the grounds that it unduly infringed shareholders’ rights. There have been a handful of successful hostile bids since 2019 and hedge fund activism is on the rise again. Assessing these developments, Milhaupt and Shishido (2023, 355) foresee a ‘measure of convergence’ between Japanese and US courts’ interpretations of the poison pill, while noting that the two systems remain on different paths.

The distinct approaches of courts and regulators to takeover bids in Japan and other countries is only part of the reason for their relative rarity in Japan. In the Bull-Dog Sauce case, what ultimately enabled the company to deflect the assault of the hedge fund targeting it, Steel Partners, was the reluctance of its shareholders to go along with Steel’s plans to increase dividends through the sale of corporate assets. These shareholders were predominantly financial services companies, strategic allies or commercial partners of Bull-Dog Sauce, who had no interest in seeing it broken up. This pattern was repeated in other failed hedge fund interventions in Japanese companies at around the same time (Buchanan, Chai, and Deakin 2012). The structure of ownership and the resulting coalition of interests in listed Japanese companies was then at odds with the logic of takeover bids and hedge fund activism of the kind that transformed corporate governance, and the wider economy, in the US and UK, in the 1980s. Unless there is a more fundamental shift in these wider economic variables, changes to ‘soft law’ corporate governance codes of the kind recently initiated in Japan, or even to the ‘hard law’ of legislation and judicial interpretation, cannot realistically be expected to have a similar impact.

Change may be coming. In November 2023, the Cosmo Energy Group decided not to activate a poison pill defence in the face of a determined activist investor campaign, seemingly because the board was not convinced that the company’s other shareholders would support doing so. An article in Nikkei Asia promptly announced a ‘requiem’ for the poison pill as an anti-takeover defence (Givens 2023). It remains to be seen how far Japan has approached what the same article described as a ‘turning point’. The corporate governance debate has undoubtedly moved on from where it was two decades or so ago when Japan’s first hostile takeover movement was effectively halted in its tracks by a combination of judicial and regulatory intervention. However, takeover bids and activist campaigns remain relatively rare in Japan by comparison to the situation in other developed market economies, and turning points have been predicted before. Toray CEO Nikkaku Akihiro’s less charitable view of the rules ‘made in foreign countries’ (Nikkaku 2021) suggests that not everyone is convinced that hostile takeovers and hedge fund activism are the answer to Japan’s corporate governance dilemmas.

The idea that Japan should modernize its current model by copying other systems seems to owe more to dogma than to experience. The evidence from other countries is that empowering shareholders through the mechanism of corporate governance reform has decidedly mixed effects. Even in the US and UK cases where hostile takeovers have been most commonly deployed as mechanisms of corporate restructuring, they do not consistently produce superior profits or returns to target companies (Cosh and Hughes 2008). The main beneficiaries, in a financial sense at least, are the targets’ shareholders, who get an immediate gain which is somewhat in the nature of a windfall for accepting the bidder’s offer to buy them out for a premium over the price at which their shares were previously trading. The performance of targets post-takeover demonstrates considerable variance, ranging from spectacular gains in some cases to catastrophic losses in others, so that on average gains and losses largely cancel each other out. Even in those cases where target companies demonstrate improved performance and profitability, leading to higher returns for shareholders, wages and employment tend to fall, suggesting that the gains from higher productivity are not evenly shared (Conyon et al. 2002). The evidence from hedge fund activist interventions in the US and UK is similar: on average they generate increased returns for shareholders, which may be evidence of improved or at least more profit-focused management (Brav et al. 2008, 2015), but reduced ones for bondholders and creditors, and for employees (Klein and Zur 2009, 2011). In Japan, aggressive hedge fund interventions have not, on average, generated gains even for shareholders (Buchanan, Chai, and Deakin 2020).

What of that other talisman of pro-shareholder corporate governance, the independent board? In the US case, it has been difficult to find evidence linking the presence of independent directors to superior corporate performance (Bhagat and Black 2002). If anything, companies with a higher proportion of independent directors appear to under-perform their industry peers during recessions and crises (Anginer et al. 2018). In the UK, there is similar uncertainty over the impact of the ‘comply or explain’ approach of the Cadbury code and its successors. Companies which neither comply nor explain actually outperform those observing the code, at least where there is a dominant shareholder. Where ownership is dispersed, the result is reversed (Arcot and Bruno 2018). In the case of companies which choose to explain their non-compliance, the quality of disclosures is generally low in the sense of being standardized and uninformative with respect to features of the reporting company (Arcot, Bruno, and Faure-Grimaud 2010).

While going against the grain of conventional wisdom on the inherent desirability of external or independent boards, on reflection these results are, again, not so surprising. Independent or outside directors are, by definition and even in a sense by design, less knowledgeable about the companies whose boards they sit on than executives and other employees. Non-executive directors may have sector expertise and they may also benefit from the experience of sitting as independents on multiple boards at the same time, but they will not have, and cannot be expected to have, an insider’s understanding of the company’s strategy and the risks it may be facing. They will be critically dependent on the CEO and other senior executives (not all of whom will be board members) for such knowledge as they do have. This dependence places non-executive directors in a precarious position when it comes to making strategic judgements on the company’s behalf, and even more so in a crisis which puts the company’s future on the line. The finding, repeated across several econometric studies (Anginer et al. 2018; Beltratti and Stulz 2012; Fahlenbrach and Stulz 2011), that US banks with a proportionately higher number of outside directors were more likely to enter into bankruptcy during and immediately after the financial crisis of 2008, confirms what was already known from studies of high profile corporate failures from the earlier ‘dotcom’ bubble and crisis of a decade before, the Enron case being simply the most high profile of several such events (Bratton 2002).

Just as the activist hedge fund turned out to be a ‘plant flowering out of season’ in the Japan of the 1990s and early 2000s (Buchanan, Chai, and Deakin 2012, ch. 8, discussing the so-called Murakami Fund), so the external or outside director model may be a transplant that the Japanese corporate governance system is prone to reject or at best co-opt to its own way of working. The large, executive-dominated board which the recent Japanese reforms have been seeking to marginalize and ultimately suppress arose in a context in which large industrial companies, so-called ‘community firms’ (Inagami and Whittaker 2005), operated as productive coalitions, seeking to find common ground between the interests of labour and finance, and focused in the final analysis on product quality rather than shareholder returns. Whatever their other shortcomings, insider-dominated boards were not easily swayed by charismatic CEOs, and regarded finance as one input or interest among many, neither prior to nor subordinated by the interests of employees. This model served the cause of incremental innovation well enough in the period when large Japanese industrial firms dominated world markets in a range of sectors from vehicle production to consumer electronics. While that era is no more, the move made by many Japanese companies over the past two decades in the direction of smaller boards with specialized sub-committees and a higher quota of outside directors has not been entirely seamless. At the point when the US-style company with committees system was being introduced in the early 2000s, along with a separation between board-level directors on the one hand and senior corporate managers outside the board on the other, concerns were already being expressed over the risks inherent in this transition, which would leave CEOs relatively less constrained by the type of collegiate decision making which had previously been the norm, and had the potential to detach boards from their companies’ wider organizational and managerial processes (Buchanan and Deakin 2008, 2009). While Japanese companies have not experienced high-profile corporate failures on the scale of those which became a regular occurrence in the US after the turn of the millennium, this would seem to have been in spite of rather than because of the adoption of board structures modelled on US practice.

In any assessment of Japan’s move towards a more shareholder-friendly form of corporate governance, account should be taken of the wider societal implications of this direction of travel. Shareholder protection norms were widely adopted around the world in the 1990s and 2000s, being enshrined in international guidelines such as those produced by the OECD, and in transnational standards including several EU directives (Deakin, Sarkar, and Siems 2018). The areas of law and regulation showing the fastest rate of change were those relating to independent boards and takeover bids, with both moving in a markedly pro-shareholder direction in the decade prior to the 2008 financial crisis. As these laws have now been in force in a large range of countries for over a decade, it has become possible to get some understanding of their long-term effects.

Shareholder dominance over corporate decision making in the US has been linked to anti-competitive outcomes and lower quality of goods and services, suggesting that corporate governance reform is not necessarily a positive sum game as far as customers are concerned (Azar, Schmalz, and Tecu 2018). A similar point applies to the interest of workers. Shareholder protection laws are positively correlated with rising inequalities of income, as measured by the Gini coefficient, and by a rise in the capital share, that is, the proportion of national income going to rents and dividends, at the expense of the labour share of national income, that is, the part going to wages and salaries (Sjöberg 2009). Second-order effects of these growing disparities include negative health impacts; through the mediating effect of income inequality, a higher level of shareholder protection in a country is associated with indicators of chronic illness, such as obesity and mental illness, and with rising child mortality (Ferguson et al. 2017).

Conclusion

The LDP has fulfilled its promise to reform Japan’s corporate governance and the mechanism it has created seems sufficiently robust to ensure that the process of supervision and adjustment will continue. However the system that has been created faces a problem neatly illustrated by the essentially contradictory opinions above submitted to the Follow-up Committee by the ICGN and the Keidanren: no one has ever succeeded in defining corporate governance in any but the most general terms without encountering the problem that different actors see corporate governance systems in very different ways. After the initial flexibility of the 2015 Code, the FSA and the Follow-up Committee have increasingly promoted a style of governance that implies a belief in adversarial relationships between investors and management predicated on agency theory and relying on rules and disclosures at the expense of principles. As the Keidanren has pointed out, substance is more important than outward form; increasingly invasive rules, often at variance with Japanese managers’ tacit understandings of good governance, threaten to undermine the legitimacy of the Corporate Governance Code and encourage purely formal compliance. Rather than intensify the weight of rules and disclosures, this seems the moment to consider how the reforms to Japanese corporate governance promoted hitherto can be given the maximum substance in actual managerial practice. It is also an opportune moment for the FSA and Follow-up Committee to consider whether corporate governance should really be seen primarily as an aid to investors and whether the direction they have taken over the past few years can really help corporate profitability and national economic revival without greater concessions to the viewpoint of corporate management.

Although the numbers of outside directors on Japanese boards is increasing, partly in response to the pressures engendered by successive amendments to the corporate governance codes noted above, it would appear that they have a largely advisory role, and do not occupy the strategic position they are often accorded on US and British boards. This may be no bad thing: a system in which outside directors can decide the fate of a company in response to a takeover bid or activist hedge fund intervention, tipping the scales in favour of asset disposals or share buybacks to placate shareholder demands, is one in which short-term financial pressures are likely to prevail over more enduring investment needs. Co-opting the outside director model to the organizational ethic of the Japanese firm may end up providing the best of both worlds, but the imposition of outside directors and related features of Anglo-American corporate governance through external regulatory pressure could equally be a distraction from efficient management and an obstacle to the long-term planning which larger Japanese firms have up to now been able to practise, with some notable successes as well as the occasional failure.

If Japan has so far mostly avoided some of the social and economic downsides of corporate governance reform, which include growing inequality, this may be because these reforms have so far had comparatively little impact in the Japanese case. If the direction of change is maintained and enforcement becomes stricter over time, with more prescription and fewer opportunities to respond flexibly to guidance, the reforms can be expected to begin to alter the behaviour of corporate actors. Takeover bids and shareholder activist campaigns may yet prove to the catalysts for wider changes in assumptions and practices. In that event, business practices which have transformed economies and societies elsewhere, beginning with share buybacks and dividend increases and extending to downsizing and rising wage inequality, will most likely become familiar features of the Japanese scene. The implications for Japan’s economy are difficult to predict but it cannot be assumed that they would be beneficial, a point which applies also to their wider social consequences.

Acknowledgments

We are grateful for comments received at the ‘Reforming Japanese Capitalism’ conference held at the Said Business School, Oxford, on 17–18 February 2023, and to Mari Sako and Hugh Whittaker for feedback on an earlier draft.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Additional information

Notes on contributors

John Buchanan

John Buchanan is a research associate of the Centre for Business Research at the University of Cambridge. He has been a non-executive director of J-Power, a Japanese electrical utility, since 2016. Beginning in 2002 he has undertaken research primarily in two areas: Japanese corporate governance and hedge fund activism. His background prior to academic work was as a commercial banker for 13 years and as an investment banker specialising in mergers and acquisitions for 15 years.

Simon Deakin

Simon Deakin is a professor of law and director of the Centre for Business Research at the University of Cambridge. He specializes in labour, corporate and private law. His books include The Law of the Labour Market (2005, with Frank Wilkinson), Hedge Fund Activism in Japan: The Limits of Shareholder Primacy (2012, with John Buchanan and Dominic Chai) and Is Law Computable? Critical Perspectives on Law and Artificial Intelligence (2021, with Christopher Markou).