The Man Behind Japan’s Governance Plan Is Feeling Pleased

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Kunio Ito
Hitotsubashi University Professor Kunio Ito. Photographer: Akio Kon/Bloomberg

The architect of a revolution at Japanese companies is a happy man.

Sipping orange juice on the 45th floor of the Ritz Carlton hotel in Tokyo last week, Kunio Ito was about to celebrate another milestone, with the nation introducing governance rules for companies that other developed countries have had for years. The snappily-dressed academic headed a 53-person group that spent more than a year reviewing business and financial markets, finally producing recommendations in August 2014 that foreshadowed many sweeping changes since, including the code for listed firms that took effect this week.

Prime Minister Shinzo Abe’s governance overhaul takes aim at companies for ignoring profitability and having docile boards, and investors for staying silent as firms squandered their money. Now both groups have new standards prescribed by the government that they must meet or explain why they didn’t. Ito already sees the impact.

“Foreign investors say there’s a revolution going on in Japan and the country’s DNA is changing,” said the friendly 63-year old, a professor at Tokyo’s Hitotsubashi University. “I can see why they’re taking it this way.”

Japan’s push to make firms more daring comes after 15 years of deflation conditioned them to cling to cash, making them about half as profitable as global peers when measured by return on equity. It’s also the result of a new urgency driven in part by fear of a stronger and more assertive China. A stock market languishing at about half its 1989 peak was further proof something needed to be done.

Sudden Revolution

Change, when it came, was fast. In February 2014, the country started rules designed to make investors press companies to use capital better. Then Ito’s team published its review, which called for greater dialogue between owners and management and said every public firm should have ROE of at least 8 percent. On June 1, the country began its first code for companies, more than 20 years after the same process began in the U.K.

The measures seem to be working. ROE for members of the Topix index was 8.2 percent at the end of March, from 5.8 percent two years before. Sony Corp., Mitsubishi Heavy Industries Ltd. and NTT Docomo Inc. are among companies targeting double-digit ROE after the Ito review. Dividends and share buybacks surged 76 percent to $104 billion last fiscal year.

“Japanese companies tend to move together,” said Ito, an outside director at Tokio Marine Holdings Inc., Seven & I Holdings Co. and at least four other firms. “We reached critical mass when Sony set its goal. I’ve been told they based it on our report.”

Cross-Shareholdings

Following the principles-based model used in Europe, the governance code gives companies the option to comply with its rules or explain why they didn’t. They include appointing two independent directors and justifying any cross-shareholdings.

Having more outsiders on boards is expected to instill more discipline at firms as they seek higher profits. Reducing shares held for relationship purposes will free up capital for better uses, while replacing friendly shareholders with those more interested in returns.

Just 416 of 1,880 companies on the Topix index, or 22 percent, had two or more independent directors as of their latest full-year filing. SMBC Nikko Securities Inc. estimates companies could sell as much as 34.1 trillion yen in cross-shareholdings.

David Herro, who oversees about $35 billion as a portfolio manager and chief investment officer at Harris Associates, says it’s great that the government is acting, but what’s really needed is for Japan Inc. to realize why the changes are good.

Boilerplate Explanations

“The big question is how companies are going to implement it,” according to Jamie Allen, secretary general of the Asian Corporate Governance Association in Hong Kong. “Some will take it quite seriously. Others that don’t care for this will find the simplest, most formulaic way around it, but over time the number of companies that see value in it will increase.”

While positive about the code, Allen also wanted its provisions to apply to all companies in Japan, rather than just those on the first and second sections of the TSE. Two independent directors isn’t enough, he said.

The success of the rules will depend on shareholders, according to Koji Watanabe, an official at the listing department of Japan Exchange Group Inc. They have to push companies whose explanations lack substance, he said.

Shareholder Role

“Investors have to try really hard on this,” he said. “But it is about improving their returns. If it doesn’t work, we could go back to a hard-law approach.”

Ito, for one, is betting that won’t be necessary. He’s preparing to start a forum for management and investors that his review recommended, seeking to reinforce its central theme: governance as a dialogue in pursuit of better profitability. He’s also looking to write a book on how Japan changed.

“This is a transformation of the country’s companies and capital markets and it’s fully under way,” he said. “I didn’t think Japan’s firms would get this onboard with ROE.”

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