Chapter 3.7 Trending on Corporate Boards: Foreign and Outside Directors

Join us in reading Chapter 3 of the book, The Only Way to Survive for Japan, subtitled "Corporate governance is sure to save our country." This book focuses on corporate governance. In Chapter 3.7, the author looks at independent outside directors from various angles. What rules are they subject to, and how can their access to non-public information facilitate the participation of ordinary shareholders to ensure good governance? The author abundantly peppers the lessons with real-life examples that serve as a primer on the rules and cautions of corporate governance.

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

Read Chapter 3.7, the 20th segment of the book:

Ramifications of Revising the Foreign Exchange and Foreign Trade Act

The plan to revise the Foreign Exchange and Foreign Trade Act was under deliberation in the Diet. In 2019, the act required foreign investors to give a notification in advance when they tried to acquire more than a 10% stake in a company. This percentage was about to be reduced to more than 1%. Domestic listed companies engaged in Japan's security-related businesses are subject to this revision.

However, this plan risked turning away foreign activists.

In reaction to criticism from investors claiming that it could hamper the liquidity of Japan's stock market, the Ministry of Finance clarified which investors were exempt from such prior notification regarding inward direct investments. They included foreign banks, insurance companies, and management companies.

However, in return, foreign investors were required not to assume posts as directors or to present to the general shareholders' meeting any proposal involving the transfer and relinquishment of their business operations. That is to say, any foreign activist who tried to request their investee companies to improve their management would most likely be excluded from this privilege.

Facilitating Constructive Dialogue

Constructive dialogue with shareholders is an indispensable element in improving corporate governance. Some activists, based on the standpoint of realizing a long-term interest, give top executives concrete recommendations, including how to improve governance. It comes as no surprise that concerned voices are claiming that this revision could impede efforts for constructive dialogues, thereby hobbling the improvement of governance.

The Ministry of Finance, in line with the enforcement scheduled in spring of 2020, said it would release a list of brands subject to the obligation to give prior notification and demonstrate specific operational procedures through a Cabinet Order. It said that it had no intention to head off activists. However, it should disclose target brands at the earliest possible time for investors to secure their predictability, lest the revision shackle governance reforms.

Furthermore, investors' opinions and views should be incorporated into the Cabinet Order to the greatest extent possible. Japan should never ever let the lost three decades continue into the future.

(The Asahi Shimbun dated November 2019)

Acquisition of 100% Ownership of a Listed Subsidiary

There are movements going on in acquiring 100% ownership of listed subsidiaries.

In November 2019, Toshiba announced that it would acquire 100% ownership of three out of four of its listed subsidiaries. Also, Mitsubishi Chemical Holdings Corporation announced that it would acquire 100% ownership of Mitsubishi Tanabe Pharma Corporation.

Through the 100% acquisition of a subsidiary, a company is able to retain profits that otherwise would flow outside the company as benefits belonging to minority shareholders. Meanwhile, it can improve consolidated operating results. Actually, by the acquisition of 100% ownership of the three subsidiaries, Toshiba's EPS (earnings per share) were most likely to improve by 21% in the fiscal year ending March 2021.

Nevertheless, attention needs to be paid to one concern. That is, there can be conflicts of interest between the parent company and shareholders of a listed subsidiary other than the parent company. The government also views this as an important concern.

Outside Directors to Prevent Shareholder Conflicts

Generally, raising the ratio of independent outside directors on the board is one of the means to prevent such conflicts of interest. For example, ISS, a proxy advisory firm, established its own criteria. It recommended against the selection of the top executive in cases where independent outside directors who met ISS's independence standards comprised less than one-third of the board of the parent company of a listed subsidiary or of any company with a majority shareholder. But as was clear from the case of ASKUL, it is questionable whether it was effectively carried out.

If the parent company desires to control its subsidiary at its own discretion, it should acquire 100% of its ownership by purchasing its shares from the minority shareholders of the subsidiary. It has always been pointed out that it is problematic for Japan to allow the existence of listed subsidiaries. Their elimination would lead to the improvement of the credibility of Japan's securities markets.

According to the statistics as of December 2018, listed subsidiaries accounted for 17.2% of all the companies listed on the Tokyo Stock Exchange. Incremental elimination of this situation is desired down the road. And, in that case, principally takeover bids based on the stock price should be employed instead of resorting to some arbitrary strategy.

(The Asahi Shimbun dated December 2019)

Takeover Defense and Independent Outside Directors

On March 27, 2020, Toshiba Machine Co, Ltd held a general shareholders meeting in which a countermeasure against hostile takeovers was resolved. Notably, this resolution was approved based on the recommendation of an independent committee composed of three independent outside directors. Its success manifests that the independent outside directors played a leading role, even in the approval or rejection of the takeover defense measure.

Why are independent outside directors being focused on now? If a hostile takeover is successfully executed, the management of a company would be forced to resign. It follows that it is difficult for the management to make objective and impartial decisions because the success or failure of a hostile takeover may determine its fate. However, shareholders only have access to publicly disclosed information, so it is not easy for them to judge whether the takeover will affect them favorably or unfavorably. In addition, if the cross-shareholding rate is high, the intent of the management could be the intent of such shareholders.

Facilitating Shareholder Access to Information

With their ability to access a company's non-public information, independent outside directors are expected to make objective and impartial decisions completely independent of the management. Of course, the premise is that governance functions properly so that independent outside directors are guaranteed to have access to such information.

But unless independent outside directors comprise a majority of the board, the full board could be persuaded in favor of the management in its decisions. Six out of the 11 directors on the board of Toshiba Machine were independent outside directors. What is worth noting is that the independent outside directors constituted the majority of the board. If the number of independent outside directors was any less, it would be quite doubtful whether the takeover defense measure could have obtained approval at the general shareholders meeting.

This impact must be much larger than it was expected to be. It can be construed that, to gain support from institutional investors in contingent circumstances, the board has to be composed of a majority of independent outside directors. The era seems to be on the horizon when independent outside directors must maintain a strong presence in terms of numbers.

(The Asahi Shimbun dated April 2020)

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