Chapter 1.2 Governance of Corporations: The Age of Outside Directors

Join us in reading this book, The Only Way to Survive for Japan, subtitled "Corporate governance is sure to save our country." Although this book mainly focuses on corporate governance, it broadly covers outside contributors and governance as a whole. Peppered with real-life examples of successes and failures, the book is also a primer on the rules and cautions of leading a corporation in Japan.

Find all published chapters at 'The Only Way to Survive for Japan'

Join us for the second part of Chapter 1:

The Evaluation of the Performance of the Board

The Corporate Governance Code has been adopted to guide listed companies since June of 2015. The Tokyo Stock Exchange has been assessing the reports on corporate governance practices, which were submitted by the end of December 2015, by companies listed on the First and Second Sections of the Tokyo Stock Exchange, and is currently disclosing its responses to the public.

Each company’s report clarifies whether it has implemented the seventy-three Principles of the Code and explains the reason if it has not implemented any of the Principles.

The least implemented principle was "the evaluation of the performance of the board," with an implementation rate not higher than 36.4%.

In the evaluation of the performance of the board, the board assesses and evaluates on its own whether it properly functions, on the whole, based on a voluntary self-evaluation made by each board member. The outcome of the evaluation is required to be disclosed in outline. It is not a common practice in Japan, but is widely practiced in the United States, the United Kingdom and other Western countries.

Openness and Evaluation

The board of directors constitutes the crux of corporate governance. However, Japan’s board of directors is criticized by investors for its exclusive nature because the real picture of the board or the details discussed in its meeting are not open to them.

It is necessary that the board voluntarily evaluates whether or not it functions effectively and that, taking such evaluation into account, it makes continuous efforts to improve its function. Such efforts by listed companies are expected to give them chances to secure trust from investors about their governance systems.

It would take time until the practice of evaluating the performance of the board permeates Japan. If a company is still not prepared to evaluate the performance of its board, it should sincerely give convincing and satisfactory explanations to the investors about its own circumstances, seeking to have fruitful talks with them. In such a way, the company can enhance credibility, which is sure to lead to the realization of the purpose of the Corporate Governance Code, ie, the improvement of medium-to long-term corporate value.

(The Asahi Shimbun dated February 2016)

Protection of Whistleblowers and Outside Directors

The Whistleblower Protection Act, which aims to protect workers who expose wrongdoing within their companies from receiving detrimental treatment by the companies, such as dismissal, has been in force for ten years, but its practicability has not yet lived up to what it should be.

Taking Olympus Corporation in 2007 for example, the company transferred a whistleblower to a position which was unnecessary for the nature of its business. What is more, Toshiba’s accounting fraud was unveiled by whistle-blowing to the Securities and Exchange Surveillance Commission, which manifests the malfunction of the company’s in-house whistle-blowing liaison.

The whistle-blowing system should be enhanced for the sake of compliance of Japanese corporations. A blue-ribbon committee of the Consumer Affairs Agency released a report proposing revision of the Act. It should be welcomed.

Whether or not an effective whistle-blowing system is implemented is largely determined by the attitude of the top executives. Previously, the top management of Teijin Limited thanked the whistleblower for exposing its unauthorized work in 2004. But I have since heard no news of the top management of any company responding to their whistleblowers positively. It can be said that the top management has been out of touch with the circumstances that surround them.

Key Duties of Outside Directors or Auditors

It is not sufficient to make the top management realize it, because if the top management is involved in wrongdoing, who else can stop it? Much should be expected of outside directors or outside audit and supervisory board members. They should serve as liaisons for whistle-blowing. What if an outside director does not function? In that case, the media should blame the individual for the lack of his/her accountability.

Some outside directors claim that they have little time to fulfill their duties. Actually, the outside directors of Ohsho Food Service Corporation had suggested setting up an independent third-party committee, and the committee made outstanding achievements, even having smoked out an improper deal in the past, which was not included in the task assigned by Ohsho. This is proof that concrete work should be outsourced.

Given this system, outside directors would be unable to employ any subterfuge to neglect their duties. Their awareness of that is the first step for revealing wrongdoing within the organization, and then any wrongdoing revealed will be subject to legal accountability.

(The Asahi Shimbun dated April 2016)

Entering the Age of Outside Directors

An epoch-making event happened spotlighting how corporate governance functions.

Mr Toshifumi Suzuki, Chairman and CEO of Seven & i Holdings Co, Ltd, had led the corporate group for more than twenty years since 1992. Then, when he became President of Ito-Yokado Co, Ltd, he was called the restorer of Seven & i. The proposal to change the president of Seven-Eleven Japan Co, Ltd, a subsidiary, in accordance with the intention of Mr Suzuki, was thrown out at the board meeting on April 7. On the same day, Chairman Suzuki immediately announced that he would resign from all his posts at Seven & i.

The proposal to change the president had been debated at "the nomination and compensation committee," which had been established by Seven & i as an advisory body to its board of directors, and the outside directors, who comprised half of the committee’s four members, had vetoed the proposal. After that, in line with the intention of Chairman Suzuki, the proposal to change the president was presented to the board meeting for deliberation. Out of the fifteen directors, four were outside directors. In the secret ballot, six votes were against and two blank, and therefore, the proposal was voted down because it could not receive a majority vote.

Outside Influence

It is thought that prior movements by Third Point LLC, a United States investment fund famous as an activist, affected the discussion at the board meeting.

Furthermore, some argue that the root cause was a conflict between the founding family and Mr Suzuki, and the movements of the outside directors and shareholders were considered to be a feint. But whatever the cause, there is no way to get to the truth from the outside.

A change of the top executive is basically the most important function of corporate governance. However, previously, many Japanese companies took it for granted that the appointment of someone to be the successor was made through closed-door discussions by the top executive and the previous top executive. The board meeting was just a place to confirm their decision.

This incident demonstrates that the hitherto convention is beginning to change. Finally, the time has come when outside directors start to function.

(The Asahi Shimbun dated May 2016)

The Change of Top Executives and Outside Directors

Cases where outside directors are involved in the change of corporate top executives are beginning to draw attention. It is a highly appreciated product of the corporate governance reform. Being in a minority, however, outside directors have no power to change the top executives on their own. Any resolution of the board meeting requires a majority vote.

The movements of the outside directors weighed a great deal in the cases of Seven & i Holdings Co, Ltd as well as of Secom Co, Ltd, because their inside directors were not functioning monolithically. Both companies had outside directors in their nominating committees, but neither of them was any more than a voluntary committee. No decision would be made in the committee of Seven & i, while in the case of Secom, the inside directors would work out resolutions unilaterally before the board meeting. Anyway, as a matter of course, in either company, final decisions were made at its board meeting.

Openly Taking Responsibility

Resolutions at the board meeting of Seven & i were made by secret ballot. Therefore, this practice was very questionable in terms of accountability to the shareholders. Although no question was raised about it at the shareholders meeting, it does not necessarily mean that the problem has been removed. Is a director who is reluctant to account for how he/she has acted in voting suited to be a director at all? More discussion should be promoted getting to the heart of the matter, namely, how to fulfill accountability to the shareholders.

In most present-day Japanese corporations, inside directors comprise a majority of the board. Given the present situation, outside directors are regarded as nothing but casting voters when inside directors fail to reach the same conclusion. But what on earth caused a split among the inside directors of Seven & i or of Secom? This time, the outside directors can be logically inferred to be the key to such occurrences.

The existence of outside directors is not a panacea for governance. It is important that inside directors and outside directors pull their own weight, seeking to improve governance in tandem with each other.

(The Asahi Shimbun dated June 2016)

Stock-based Compensation for Officers

The proposition to increase compensation for officers is being debated as a means to better corporate governance. It is intended to encourage officers to promote "aggressive management."

Previously, when a company adopted performance-based compensation, having forsaken fixed compensation, it would grant stock options to its officers only in the form of options. Hitherto, the law had not allowed a company to grant its own stock to its officers. However, since this legal restriction was repealed, the number of companies that have decided to adopt this stock-based compensation has been soaring.

According to Mitsubishi UFJ Trust and Banking Corporation, the companies which have employed stock-based compensation during the period from April to June of 2016 numbered 121, more than three times as many as 39 in the year-earlier period.

Stock-based compensation is expected to serve as an incentive for officers to strive for medium-to long-term enhancement of corporate performance. Furthermore, unlike stock options whose exercise price is the current price of the company’s stock at the time of issuance, stock-based compensation will not disincentivize officers even during a time of declining stock prices due to deteriorating economic conditions. Rather, it will help align the company’s interests with those of its shareholders. It can help the company run the management in line with shareholders’ viewpoints, and it seems to be welcomed by institutional investors as something that can satisfy their desires.

A Practical Approach

Is there any problem lying there?

In the case of stock-based compensation, the amount of compensation practically differs according to the stock price in the market. Therefore, there is some concern that it might spark a temptation to wrongfully achieve such a stock price that would hardly happen under ordinary circumstances. Actually, in the Enron scandal, corporate top executives had received a great deal of compensation by cooking the books in one way or another. We are definitely required to devise an appropriate system that will make incentives work for the enhancement of corporate performance, while preventing wrongdoing from occurring.

This objective absolutely necessitates proper advice and supervision of outside directors completely independent of the corporate top executives. Whether nominating committee or compensation committee, it is urgent for a voluntary committee to embark on establishing a practical and workable scheme.

(The Asahi Shimbun dated July 2016)

Follow the book from Chapter 1, as it is published.

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