In the coming months, Japan is set to reach another important milestone in its path toward improving the business environment with the first set of revisions to the 2015 Corporate Governance Code. The changes -- which focus on unwinding cross shareholdings, broader adoption of compensation and nomination committees, and greater diversity on boards -- are important steps in moving Japan closer to global governance practices.
The proposal by the Financial Services Agency, the regulator, comes after a series of well-publicised management problems at several large Japanese companies, which has increased attention on governance practices. The draft changes are open for public comment until April 29, after which the Tokyo Stock Exchange plans to issue the finalized code in June. Companies will be given until the end of this year for implementation, but we may see reforms from some groups as early as June during their annual general shareholder meetings.
The revised code calls for companies to disclose plans to reduce strategic shareholdings. It also introduces new supplementary guidelines that prohibit companies from threatening to cut-off business relations if cross shareholdings are sold, and requires that all transactions be conducted on an arms-length basis. The regulatory focus on challenging vested interests and boosting capital efficiency is clear.
Goldman Sachs Research has found that improvements in certain environmental, social and governance (ESG) factors can both reduce risks and contribute to increased returns for shareholders. The elimination of cross shareholdings, for example, can improve returns on capital and investor engagement. Despite progress over the past two decades, Japan's strategic shareholding ratio remains at an elevated level of nearly 30% of the market, compared to a U.S. level of around 5%. This can reduce corporate returns on equity through inefficient capital allocation, and can insulate management from shareholder interests and engagement.
Many Japanese companies have historically justified cross shareholdings by stating that such holdings help with "maintaining relationships with customers," "strengthening relations with counterparts," or "strengthening ties with other companies." But the new guidelines clarify that business relationships will no longer be a valid rationale for strategic shareholdings. Although some companies may modify the logic behind their cross shareholdings, the proposal will still likely help to reduce cross shareholdings and provide support for investors asking corporates to unwind their holdings.
Enhancing explicit board responsibilities are another major focus of the proposal. These changes emphasize the importance of the board's duty not only to appoint a CEO, but also to dismiss them when appropriate. The draft code also calls on the board to play an active role in creating CEO succession plans and states that companies that do not have a majority of independent, outside directors on the board must establish independent advisory committees, including nomination and remuneration committees.
This proposal could trigger wider adoption of board advisory committees; currently, independent directors hold less than half the board seats at 95% of TOPIX companies, and only one-third of the companies have a nomination and/or remuneration committee. Adopting committees is a welcome first step in ensuring boards represent the best interests of shareholders through independent oversight of management appointments and compensation.
However, many companies in Japan do not fully disclose committee membership and when they do, CEOs are frequently on their own compensation and nomination committees. This contrasts starkly with global standards, which include committees solely comprising independent members, transparent long-term performance-based compensation KPIs (key performance indicators), and say-on-pay provisions for shareholders, aimed at removing conflicts of interest and preventing entrenched managements from helping to set their own remuneration. Metrics such as return on invested capital are typically among the most effective KPIs for enhancing shareholder returns and stock performance.
For committees to be independent, Japan's corporate boards will first need a higher level of overall director independence. The 2015 corporate governance code required companies to have at least two independent directors, with a recommended level of 33%; this bar has not been raised further in the 2018 revised draft.
Despite this, it is nonetheless encouraging to see that the draft includes a new reference to diversity, stating that boards must have a level of diversity, including gender and internationality, to ensure they can operate effectively. This is the first time that gender diversity has been mentioned in the Corporate Governance Code. Movement toward greater board diversity will also help move Japan toward global norms. It is also likely to help companies develop a more diverse workforce which our research has linked to greater shareholder returns.
Japanese companies are still well behind global peers when it comes to gender diversity, with 56% of Japanese boards having no female directors. In comparison, in the U.S. and Europe, the median board has 20% and 27% female director representation, respectively. Some European countries achieved this with the help of regulatory quotas, while others improved through softer measures such as corporate governance codes and industry bodies like the U.K.'s 30% Club. With fewer than 5% of Japan's board seats filled by women, the nation is now increasing its focus on driving change. Further code revisions may be needed to address this problem, and in the areas of board independence and compensation transparency, to bring Japan's corporate governance standards closer to global practices.
Chris Vilburn is head of GS SUSTAIN Japan, Goldman Sachs' long-term investment strategy and ESG research team. He previously worked at Japan's Shinsei Bank with the chief investment officer team.