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Alicia Ogawa: Inbred management structures are hurting corporate Japan

Outgoing CEOs never truly retire, they just hinder the next generation from leading

Skeptics of Japan's corporate governance reform can point to the recent spate of malfeasance at big-name companies.   © Reuters

Japan's corporate governance and stewardship codes, introduced less than four years ago, represented nothing less than a call to redesign Japanese capitalism.

On the surface, the resulting pace of transformation has been lightning fast. The regulators and the Japan Exchange Group, which operates the country's stock markets, have demanded that corporate legal structures and boards be thoroughly reorganized. New duties and disclosure requirements have been set for fund managers, and to a large extent, they are being obeyed.

Yet there is frequent grumbling from the likes of the Financial Services Agency, the Ministry of Economy, Trade and Industry and foreign investors about Japan Inc.'s slow pace of change. To outsiders who are not following the minutiae of newly revised corporate organization charts, it seems hard to fathom what is different. The recent torrent of reports of corporate malfeasance at companies including Nissan Motor, Mitsubishi Materials and Kobe Steel would seem to justify this skepticism.

The problem, however, lies not with regulators, nor even in the level of acceptance of Japan's new rules, which is in fact quite high. Some 89% of listed companies now comply with at least 90% of the requirements of the corporate governance code. The FSA and the economy ministry have created a radically improved monitoring system for financial capital and disclosures. The Government Pension Investment Fund, itself newly reshaped into a force for stronger market discipline, is providing oversight of environmental, social and governance factors.

However, there is no specific entity of similar power focused primarily on overseeing human capital. More specifically, tribal loyalties, on which too much of traditional corporate Japan depends, remain as strong as ever.

IMMOBILE STAFF While a 2014 government survey showed that half of workers under 35 no longer worked for their first employer, worker mobility at the mid- and senior manager level of large companies is still negligible. Of all men aged 40-45, only 6% had ever changed employers. Among executive directors of major companies, it is difficult to find any who have worked for another company.

This leads to two roadblocks that restrict the creativity and resilience of almost every Japanese company.

First, it is not possible to recruit the very best candidate for a given job since the choice is effectively restricted to people brought into the company years ago straight out of college. The faster the pace of technological change outside the company, the more problematic this restriction becomes. Second, each worker's job security and career progress depend upon unquestioning loyalty to his or her immediate boss.

Increasing the ability of workers to change jobs and reducing expectations of allegiance to managers would greatly advance the progressive reforms introduced by regulators. Recent fraudulent behavior indicates what may happen when employees are afraid to speak truth to power for fear of their own positions.

As chairman and chief executive of electronics maker Sharp, Katsuhiko Machida expanded aggressively into the liquid crystal display business. After retiring in 2012, Machida stayed involved as a senior adviser. During the three years that he held that position, Kozo Takahashi, his successor as CEO, steadfastly refused to reduce exposure to LCDs in spite of falling prices and growing competition. The company ultimately had to be rescued from collapse by Taiwan's Hon Hai Precision Industry, also known as Foxconn Technology Group.

Scandals seen at companies such as Toshiba, Toray Industries and Obayashi came to light because employees made anonymous allegations to reporters. They either did not highlight problems to their superiors or were essentially ignored.

The most important way to combat the intimidation of managers by their seniors would be to do away with the longstanding use of sodanyaku or komon, both usually translated as "adviser." These are positions created for CEOs like Sharp's Machida and other top executives, who upon retirement are given a salary as well as perks referred to as CRS: a car, a room for an office and a secretary.

Scandals like the one at Kobe Steel highlight the need for Japanese workers to feel more empowered to bring attention to problems.(Photo by Kosaku Mimura)

Such former managers have no official responsibilities. However, their continued presence often serves to intimidate successors who might otherwise be tempted to overturn policies or previous investment decisions. The influence of the sodanyaku is frequently cited as a reason Japanese companies are slow to divest non-core businesses.

One of the reasons some say the sodanyaku system is necessary is to provide post-retirement income to compensate former executives whose salaries were low relative to global peers. This argument has become weaker given the recent trend of offering stock options as a component of executive compensation.

A handful of companies have announced that they are doing away with sodanyaku. The Tokyo Stock Exchange announced last summer that it will require disclosure of the presence of such retired executives at listed companies, as well as a description of their duties and employment terms.

This will likely lead more investors to question their presence, particularly foreign investors for whom this practice is likely unfamiliar.

FLOW OF OUTSIDERS If the aim is to increase job mobility and workforce liquidity, starting at the top would be most effective. If retiring executives are no longer made sodanyaku, there will be an increase in the pool of available talent to serve as external directors at other companies. The more outsiders on boards, the more comfortable internal managers will become with their presence and the easier it will be for them to welcome other outsiders. Group loyalty will then become less important than professional merit.

There are several other ways to encourage this.

Some 83% of publicly listed Japanese companies lack a formal committee to oversee the nomination of senior executives. Nominating committees should be made mandatory, staffed by independent directors, and members should be required to certify they have considered outside candidates when filling management positions.

A few forward-looking companies have started to recruit graduates of foreign universities as well as bring in new staff at later entry points. Some government ministries as well as recently privatized companies such as Japan Post are introducing flexible work contracts that allow them to hire outsiders with specific talents for a fixed period with a substantial bonus for good performance. This is an example the private sector should follow, too.

The key though is to start with incentives for top executives, which currently too often reward loyalty and harmony above merit and innovation.

Alicia Ogawa is director of Columbia Business School's project on Japanese corporate governance and stewardship.

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