Making Japan Inc work for investors

Last month (June 2018), the Japanese Financial Services Agency rolled out the first revision to its Corporate Governance Code. The improvement in corporate governance in Japan has played a big part in the Abenomics Japanese equities recovery story. This much-anticipated revision will provide further impetus for Japan Inc to behave more in line with the rest of the developed world when it comes to considering shareholder returns.

The original code was first implemented in 2015. Half a decade ago, it would not be unheard of for a CFO or IR person not to know their firm’s ROE. Now, you will find many company meetings start with what the company is doing to improve shareholder return. This shift in attitude has made a big impact on the market as a whole, as can be seen from the growth in dividends and share buybacks shown in the chart below.

The cause of the change in mentality, as is the case with many important social changes in Japan, came from the top – the Prime Minister’s office. While foreign investors were sceptical when the original – mildly worded – Corporate Governance Code came out, it has provided the push Japanese corporates needed. The most effective measure was to ensure compliance with the code by asking firms to ‘explain’ any non-compliance; the prospect of losing face was enough to prod firms into taking action.

Three years on, the Japanese stock market has come far, but it still has further to go. The revision to the Code focuses on three aspects of corporate governance:

  • Enhanced Board committees
  • Unwinding of cross-shareholdings
  • Engaging with Japan’s corporate pension funds.

These reforms are crucial for the Japanese stock market to realise its full potential for its investors, and if the original code is anything to go by, we can anticipate changes to corporate behaviour on these points.

Let’s break these items down. For decades, Japanese corporate boardrooms have been filled by company founders and men who have dedicated their entire life rising through the ranks of the corporate structure. Currently, less than half of directors on 95% of Japanese boards can be considered independent. Furthermore, only a third of TOPIX constituents have a nomination or remuneration committee. Diversity is also low at the board level. Even now, several years after the start of Abe’s “Womenomics” drive, only 5% of board members are female and over half of the firms do not have any female directors. This creates a conflict of interest between (the often) long standing chairmen, chief executives and the shareholders.

Another long standing structural problem with Japan’s corporate governance is cross-shareholding. This is a legacy of Zaibatsu from the bubble era, further complicated by large scale mergers that have taken place subsequently. In Game of Thrones terms, holding each other’s shares was the equivalent of marrying off your offspring to another family in exchange for alliances. The days of Zaibatsu has long gone, but unwinding cross shareholdings has been difficult, again, for the fear of losing face to business partners. The revision of the Code forces companies to explain how shareholder return can be improved if they choose not to unwind the cross shareholdings. The shame of having to explain to investors will now surely outweigh the shame of selling shares in partner companies.

The government, through the revised Corporate Governance Code, is twisting the arms of Japanese pension funds, to hold companies accountable and encourage change. Foreign active investors and private equity houses have already been proactively engaging with Japanese firms for the past several years, but now the large Japanese fund managers have also confirmed that they will be exercising their votes to ensure good governance by firms. With assets under management of USD500 billion behind them, the Japanese corporate pension funds will provide the fuel that is needed to re-ignite the flames that are burning through Japan Inc’s outdated business practices. What emerges will be a far more shareholder-friendly market.


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