Abe Rewrites Rules to Rouse Japan With Governance Revamp

As his nation’s economic revival wanes, Shinzo Abe is trying to turn around Japan Inc.

Abe’s Liberal Democratic Party is plotting sweeping changes to rules for how companies are overseen, aimed at boosting profits and markets. Change has come slowly in a nation where firms produce the second-lowest return on equity among developed markets, have the fewest independent directors and no enforceable corporate-governance code.

The Topix index’s 12 percent drop this year is adding to pressure on Abe to get further with reform, after the business lobby resisted past attempts. Investors and the ruling party are hoping this time is different amid signs Japan is more receptive to change after exiting deflation.

“The wheels are finally in motion,” Kathy Matsui, chief equity strategist at Goldman Sachs Group Inc. in Tokyo, said by phone. “This is actually one of the biggest items of the third-arrow reforms, and could produce real change. It won’t happen overnight, of course. It will take time. But the scope to get better is pretty tremendous.”

The financial regulator finalized a stewardship code for institutional investors on Feb. 26. Lawmakers began the parliamentary process on April 8 on legislation to push for more outside directors. The LDP will present a proposal in June to create standards guiding firms on governance, the party said on Feb. 27.

Much is at stake. After record monetary easing weakened the yen and sent the Nikkei 225 Stock Average up 57 percent last year, its biggest annual gain in four decades, Japanese shares are slumping the most among developed markets. Economic growth in the three months ended December was a quarter of the pace initially expected by strategists.

Must Work

“Corporate governance has to work,” Yasuhisa Shiozaki, deputy policy chief of the LDP, said in an interview in January. “Otherwise, companies won’t boost competitiveness.”

Companies that rank highest on standards including board independence and performance-linked pay are projected to return an average 8.8 percent on equity over the three years ending March 2015, Goldman Sachs said in an August report, compared with 5.5 percent for firms with the lowest ratings.

Japan came 35th out of 38 markets globally for corporate governance in 2010, according to a survey by Governance Metrics International. Just 19 of the Topix index’s 1,780 members, or 1.1 percent, had a majority of independent directors at their most recent full-year filing, compared with 65 percent for the MSCI World Index of developed-market shares, data compiled by Bloomberg show.

‘Yes Men’

Recent governance breakdowns have cost investors. The market value of Olympus Corp. plummeted about 80 percent after Michael Woodford, the endoscope maker’s former president, went public in 2011 with accounting discrepancies the company initially denied. Olympus, which dismissed Woodford from the post, later admitted a $1.7 billion fraud. The board was replaced and some executives received criminal convictions. The company said yesterday it was sued by six banks seeking damages totaling 27.9 billion yen ($274 million).

“The reality is that you have a docile media, institutional investors who act to protect ‘the club’ and boards filled with yes men,” Woodford said. “You have to change the whole society and these rules won’t do that.”

Daio Paper Corp.’s former chairman was sentenced to prison in 2012 after spending the company’s money in casinos. Mizuho Bank Ltd. Chief Executive Officer Yasuhiro Sato said he would step down after the group was caught financing gangsters. He will remain head of Mizuho Financial Group Inc.

Low Returns

Return on equity at Japanese companies in the 10 years through 2013 was among the lowest of 24 developed markets tracked by Bloomberg. The Topix’s average was 6 percent, beating only Greece’s ASE Index, the data show. Companies in the Standard & Poor’s 500 Index delivered 13.6 percent. The U.S. equity gauge rose to a record on April 2, while the Topix remains 60 percent below a 1989 peak. The Japanese gauge slid 0.1 percent today to close at 1,149.49 in Tokyo.

The first part of Abe’s overhaul, a stewardship code based on U.K. guidelines, targets asset managers. Institutions that choose to sign up must comply with seven principles or explain why they didn’t. Fund managers are expected to monitor and engage with companies, publish guidelines for how they do so and disclose how they exercise their voting rights.

“It’s certainly better than what we have now, which is no real framework for enforcing fiduciary responsibility for asset managers,” Goldman Sachs’ Matsui said. “I’m told managers of public money, for example, will have to comply, or that money will walk out the door.”

More Outsiders

The second part seeks to bring more outside faces to the developed world’s most insider-filled boards. Changes to the Companies Act are currently being debated in parliament, after Abe said in a January speech in Davos, Switzerland, that the law would be amended by June. Firms will have to appoint an outside director or explain why they didn’t, according to a draft of the bill published on the Ministry of Justice website.

Independent directors made up an average 8.8 percent of board members for companies on the Topix as of most recent full-year filings, according to data compiled by Bloomberg. That compares with 84 percent for the S&P 500 and 42 percent for Hong Kong’s Hang Seng Index.

The change would be a step forward from prior attempts by the Democratic Party government, which recommended similar principles but didn’t force boards to address a lack of outside directors at their annual meetings, where a shame factor applies, according to Nicholas Benes, a representative director of The Board Director Training Institute of Japan.

“If the law is passed as currently proposed, the LDP will have substantially strengthened the ‘explain’ part of ‘comply-or-explain,’’ Benes said by e-mail Feb. 22.

Business Lobby

Keidanren, the business lobby that counts about 1,300 of Japan’s 3,740 listed companies as members, has traditionally opposed change to the way Japan Inc. does business and views corporate governance as a moving target.

‘‘All each company can do is find the most suitable way for them while complying with the laws,’’ Yasuhisa Abe, director of the group’s business infrastructure bureau, said in an interview in Tokyo on Feb. 26. ‘‘Keidanren isn’t against outside directors themselves, we’re against making them mandatory. Also, companies that have them are increasing.”

About 62 percent of firms listed on the Topix had at least one outside director last year, from 30 percent in 2004, according to data from the exchange. Canon Inc., the world’s largest camera maker, said in January it would appoint the first such board members in its history. Toyota Motor Corp., Japan’s No. 1 company by market value, made the same decision last year.

“The appointment of outside board members shows Toyota has opened up more and become fully global,” Fujio Cho, outgoing chairman at the time, told reporters.

Governance Code

The last part of Abe’s governance plans is a broader code to guide company behavior. The LDP is discussing details and will present a proposal to government in June, said LDP lawmaker Masahiko Shibayama, who heads a financial markets and governance reform group within the party.

More than 70 countries already have equivalent guidelines, according to International Finance Corp. The U.K. code, introduced in 1992, encourages companies to have a separate chairman and CEO. All except smaller firms should have a majority of non-executive, independent directors. Codes in France and Germany are also on a “comply-or-explain” basis, while the U.S. includes its governance requirements within exchange listing rules, which are based on the Sarbanes-Oxley Act of 2002.

TSE Principles

The TSE established principles in 2004, based on guidelines at the OECD. They took three years to develop and fall short of providing specific provisions for companies to follow, according to Japan Exchange Group Inc., the bourse operator.

“They’re principles, not a corporate governance code,” said Masaki Shizuka, a managing director at Japan Exchange. “Of course we don’t think they’re sufficient. But even if we tried to do something more stringent, we can’t do it by ourselves. One option is that politicians enshrine it in law, and there are also other ways of approaching it.”

For BDTI’s Benes, while the developments so far are positive, much depends on what happens next.

If the LDP follows through with its plans, “a virtuous cycle will emerge” and shareholders will benefit, Benes said. If not, “the investor community will be disappointed once again.”

Before it's here, it's on the Bloomberg Terminal.