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Opinion

Japan's stewardship framework for investors needs urgent reform

Current rules hinder mainstream institutions from acting as better stewards

| Japan
Japan's Financial Services Agency chopped off with one hand many of the "engagement" benefits that its stewardship policy hand had just promised.   © Reuters

Nicholas Benes is chief executive of the Board Director Training Institute of Japan.

When Japan was drafting its first stewardship code for investors in 2013, I proposed that it also set forth a corporate governance code, which was then drafted the following year.

The very first line of my presentation to Japan's ruling Liberal Democratic Party pointed out that the stewardship code could not possibly function well without a corporate governance code requiring disclosure about governance practices at each company. I explained that the codes would serve as "two wheels of a cart," supporting each other.

Ever since then, this two wheels analogy, along with the words taiwa, or engagement, and stewardship, have echoed throughout the country.

However, seven years later, the fine print of Japan's stewardship framework still leaves much to be desired compared to the U.K. model that Japan's Financial Services Agency sought to emulate.

When most foreign institutional investors think of engagement, they imagine a two-way dialogue in which they can communicate their opinions and suggestions about matters such as capital structure, dividend policy, board composition and so forth.

In the U.K., investors are free to do this and to keep the fact of such discussions confidential -- something that the investee company may also desire. If a large institutional investor buys more than 3% of a company's stock, it will have to file a simple large holding report and then refile it each time it increases its stake by 1% or more.

But at no time will it have to disclose its purpose of holding the stock or its intent to make suggestions, unless perhaps its aggregate holding percentage nears the U.K.'s mandatory TOB level of 30%. Up until the point at which a change of control might easily occur, it is considered unremarkable that investors might make suggestions to investee companies. In fact, it would be thought rather odd if they did not, given their stewardship duties.

But in Japan, if a major asset manager buys up to 5% or more of the company's shares, it will have to ask itself, "on behalf of our beneficiaries, might we want to make suggestions, or strong hints, about such matters?"

If so, it will have to not only publicly report to the FSA, but also specify that its investment is not "purely for investment purposes" because it intends to "make suggestions about important actions" by the company. "Suggestions" are listed in the regulations and include most things diligent active fund managers should want to discuss as stewardship code signatories.

Indicating the possibility of making important suggestions requires more frequent internal monitoring and reports to the FSA, which must be done separately from the much more convenient filing system that applies if one does not do the work of making suggestions.

In the case of collective engagement, potential burdens are magnified due to the possibility of having to coordinate a joint filing for all members of the collaborative group owning more than 5%. The system is essentially saying to these investors, "before meeting to meaningfully engage with the company, please stamp on your forehead the words 'possible activist' for public viewing."

These rules pour cold water on the concept of effective "engagement" by positioning it with negative overtones and in the public view. They also throw sand in the logistical gears of large institutions' compliance systems.

Japan created this burdensome reporting regime in 2006 after a spate of activist attempts had universally failed to scale the walls of citadel Japan. Then, in 2014 the FSA created the stewardship code, extolling the virtues of "stewardship."

However, the FSA did nothing to modify its reporting rules for large holders in line with the U.K. model. To the contrary, while mimicking the framework of the U.K.'s stewardship code, it issued materials clarifying that the 2006 rules would remain firmly in effect.

By reaffirming the old rules, for practical purposes the FSA chopped off with one hand many of the "engagement" benefits that its stewardship policy hand had just promised. Other ironies have appeared. Although in 2006 the rules had been intended to slow down activists, nowadays such investors often just make demands in public announcements, thereby skirting the rules applying to "important suggestions."

Result: the rules no longer deter activists much at all. Instead, they simply burden large mainstream institutional investors, especially passive funds, and hinder them from acting as better stewards.

The divergence between the U.K. and Japan is directly reflected in the stewardship codes of the two countries. The U.K. stewardship code proactively states that "signatories, where necessary, participate in collaborative engagement to influence issuers" and encourages signatories to disclose the collective engagements in which they participated. Many institutions do exactly that.

In contrast, Japan's stewardship code merely states that "depending on the need, it is possible that collective engagement may be beneficial."

Collective engagement is fast expanding into the world of environment, society and governance-related suggestions and shareholder proposals -- in Japan as well. To its credit, in Japan's new corporate governance code, the FSA took a proactive approach on ESG, for instance, by requiring climate-related financial risk disclosures.

It would be a shame if mere bureaucratic inertia prevents the agency from aligning its own 2006 regulations with the needs of Japan of 2021.

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