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Hedge Fund Monthly
 
Corporate Governance in Japan – Same as it ever was?
Jeffrey Levy, FreeSpirit Advisors August 2006
 
Some participants in the Japanese stock market cite significant improvement in Japanese corporate governance as a motive for increased foreign participation. Perhaps, however, the causal relationship is really the reverse, that is, increased foreign ownership of Japan, Inc has forced improvements to corporate governance.

Enthusiasts offer evidence of a newfound embrace of minority shareholder interests including quarterly reporting, mark-to-market accounting, increased payout ratios and even share repurchases. They claim that such efforts will help prevent a return to the bad old days of the 20th century. In those heady days, the shareholder was so completely seduced by the prospect of capital appreciation that basic concepts such as return on capital, transparency, investor relations programmes and dividends were subordinate to corporate egomania – an urge to grow revenues and market share at any cost. This urge led to some of the uglier excesses of the ‘bubble’ economy, where Japanese companies employed shareholders’ equity to build monuments to their own supposed invincibility. The most obvious examples of this wastage were the high-profile real estate transactions of some of Japan’s behemoths. Who can forget the acquisition (and subsequent sale) of such trophy properties as the Rockefeller Center (Mitsubishi Estate) in New York City, supermalls in Hawaii (Daiei) or the now defunct Electronics and Industrial Enterprises’ apparent attempt to purchase most of eastern Australia? Less obvious but far more damaging was the steady build-up of excess capacity in almost all sectors of corporate Japan.

But life on the board was so much easier then. The Japanese market’s seemingly unstoppable march forward was certainly partly to blame for investor myopia, but the cosy relationship between corporations and their key shareholders was also important. Indeed, the free float of the Japanese market’s capitalisation was probably no greater than 35% until the end of the 1990s. Large chunks of equity were held in institutional cross-holdings, an intricate and enormously lucrative matrix of ‘you scratch my back and I’ll scratch yours’ relationships. For example, a bank would purchase a large equity holding in a company to cement its position as main banker to that corporation. The bank would assure the company that it would never sell, thus assuring the management of a dependable and perennially supportive partner. In return, the company would turn to the bank for its borrowings. Such relationships may have ultimately prolonged Japan, Inc.’s misery in the post-bubble hangover, as the banks were initially only too happy to continue to lend, and ultimately perpetuated the bad lending policy in part to protect their equity investments! Obviously, none of this helped to encourage a focus on minority interests, let alone that the reform that was so badly needed.

So what happened between the end of the 1990s and now to make the foreign investor believe that Japanese companies have transcended this mire of vested interest?

Simple – a little bit of desperation was injected into the mix. By the end of the 1990s, banks were forced to clean up their loan books. They were forced not out of shame or even a newfound desire to do good, but because their collective demise was upon them. Indeed, august institutions such as the Nippon Credit Bank and the Long Term Credit Bank of Japan ultimately did fall victim to their thoroughly diseased loan books. Thus, banks and insurance companies were forced to dispose of many of their strategic equity holdings in order to satisfy basic capital adequacy requirements. Initially, the banks made some efforts to ‘place’ the shares with ‘acceptable’ (to the issuer) holders. Some equity was sold to regional banks who wanted to build relationships, for example. Some equity was even retired by those corporations who could afford to do so. However, the sheer amount of stock coming unstuck was too great for Japanese financial institutions to absorb on their own, especially in a market environment where the end-investor was (and maybe still is) wary of equity investments.

So the Japanese company was forced to turn to the foreigner. This was a terrifying prospect. The likelihood of finding overseas shareholders who would not interfere with local management was slim, and not many companies wanted to allow any single overseas institution to hold a strategic stake in its livelihood.

Yet the prospect of a market disposal of these institutional cross holdings was equally unappetising.

Investment bankers worked overtime in the first few years of the new century to find new holders with whom to place these share parcels, and entertained all sorts of schemes to prevent the liquidity flooding the marketplace. One idea was to issue ADRs and GDRs, effectively locking up the liquidity offshore. One of the by-products of investigating this path was an interest in understanding the reporting requirements under the US SEC law.

As the prospect of increased foreign shareholding became inevitable, so began the inexorable shift to greater transparency and, in many cases, the provision of US GAAP reports. This coincided with a number of regulatory changes in Japan, including a move from semi-annual to quarterly reporting, and mark-to-market accounting. Let us be clear however, that none of these changes were adopted voluntarily – they were forced upon Japanese companies either by desperation or obligation. Either way, the impetus was entirely exogenous.

Since the introduction of quarterly reporting two years ago, commentators have delivered mixed reviews. While there can be no doubt that the increased communication is a positive development, one has to consider the possibility that it simply provides a more regular forum for obfuscation and chicanery. In our experience, we have experienced no significant change in the incidence of earnings surprises.

The arrival of the so-called ‘activist fund’ has also provided a fillip to the booster of improved corporate governance. Such funds are hoped to become the ‘conscience’ of corporate Japan. However, the success of such funds has been limited. Typically, the fund manager has engaged in sabre-rattling, which has coincidentally increased the target’s share price. Typically, the fund has abandoned the position (almost always at a significant profit) before enforcing real change. In some markets, this kind of activity is known as ‘greenmailing’. More to the point, the advent of such tactics has often sent Japanese management into a retrograde frenzy, hastily altering articles of incorporation, organising ‘poison pill’ defences, and jawboning public sentiment against the corporate marauder who might be threatening the best interests of the employees.

Corporate reform is still nascent in Japan, and it is unclear whether the environment will continue to sponsor positive change. First, we must consider the fact that most improvement in profitability has come through cost-cutting. After its ‘lost decade’, Japanese companies have in general done a fine job of reducing excess capacity and reforming bloated cost structures. However, if these companies are to properly position themselves in a recovering economy, they must begin to focus again on the top line, that is, growing sales and share. Foreign participants are advised to exercise great scrutiny in evaluating this shift, ensuring that in the process, we do not see a return to Japan, Inc’s wicked old ways.

Finally, we must also consider the political environment. At this time, it is entirely unclear as to who will succeed Prime Minister Koizumi, and whether the reforms that he has embarked upon will continue to receive government sponsorship. The record of the Liberal Democratic Party in this area is hardly encouraging.

Vested interests are still deeply entrenched in corporate Japan, and we must not misinterpret the motivation of recent change.


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