Another compressed Japanese proxy season is just around the corner – what should shareholders expect? As always, director and board independence will continue to be a major focal point. However, unlike previous years, we are expecting to see numerous Japanese companies adopt several changes, including the One-Tier Board with One Committee structure, due to the recent legislative and regulatory efforts to strengthen Japan’s corporate governance practices. Finally, a debate in Japan has arisen as to the effectiveness of ROE as the primary corporate performance measure.
In February 2014, the Japanese Stewardship Code was introduced to promote responsible investment by institutional investors. On May 1, 2015, the partial amendments to the Companies Act brought about a notable change by introducing a new board structure for public companies: the One-Tier Board with One Committee structure. Companies with this new structure will not be required to establish remuneration and nomination committees, unlike companies who have adopted a One-Tier Board with Three Committee structure. Furthermore, the Corporate Governance Code (the “Code”), which includes a principle that recommends companies to appoint at least two independent outside directors, is expected to have a significant impact on the 2015 proxy season.
Effectiveness of the Japan Corporate Governance Code
Investors have come to recognize that Japan has traditionally adhered to poor corporate governance standards, and this has presented a significant challenge for investors when it came to proxy voting: the lack of board independence, concentrated meeting dates, late proxy material distribution, poor disclosure practices and the necessity for manual procurement of information all have presented a challenge for shareholders during the proxy season.
However, the Code, which is set to take effect on June 1, 2015, aims to resolve many of these issues in an effort to improve Japanese corporate governance overall. The Code will be on a comply-or-explain basis; any companies which choose not to implement any of the new standards or recommendations will be required to disclose an explanation of such decision(s) to their shareholders. However, we believe most companies will choose to comply, as evidenced by an increasing number of issuers engaging in the appointment of multiple outside directors, as well as numerous issuers providing early disclosure of proxy materials (as well as English disclosure of its proxy filings).
New Board Structure: One-Tier board with One Committee
The conventional board structure for Japanese companies is a two-tier board structure, comprised of the board of directors and the board of statutory auditors. The board of directors of a two-tier board company have traditionally been dominated by insiders and the lack of board independence has long been criticized by non-Japanese investors.
Amid pressure from investors, the 2015 Companies Act finally implemented measures to encourage companies to appoint at least one outside director (on a comply-or-explain basis) as well as introducing the aforementioned new board structure for public companies (one-tier board with one committee). Additionally, the Code included a provision recommending that companies appoint at least two independent outside directors. Initially, concerns and doubts emerged as to whether companies would actually adopt this new board structure. While the overall goal of the new board structure is to improve a company’s corporate governance framework, certain companies may be looking into the new structure in hopes to evading more stringent requirements to be enforced under the traditional two-tier board structure. Effective June 1, 2015, companies with the two-tier board structure will be required to appoint at least four outside members: two outside directors are recommended by the Code, and at least two external statutory auditors will be required by the Companies Act. However, if a company is able to shift to a one-tier with one-committee structure, it will only be required to appoint two outside directors. Furthermore, such companies will not be required to establish any other board sub-committees beyond the audit committee, like those required under the one-tier with three-committee structure. Ironically, the requirements under the new one-tier with one-committee structure are comparatively lax than the those of the traditional two-tier structure, as companies would be required to secure fewer outside members to its board, and may become a leading factor for many companies electing to shift to the new board structure.
This new board structure appears to be somewhat popular already: as of May 27th, more than 150 companies have announced an intention to switch to this structure. Clearly this is a new trend for 2015 that investors should keep an eye on in 2015.
Should Investors Focus on ROE?
The Ito Review, a report published by the Ministry of Economy, Trade and Industry (“METI”) in 2014, recommended that Japanese companies attain ROE of 8%, citing that many companies have been recording subpar ROE of less than 5% in the past. The Ito Review placed the spotlight on ROE for Japanese companies and has become another significant point of discussion for the 2015 proxy season. Some shareholders it appears will hold top management accountable for low ROE. The best example of this so far is at Kirin Holdings, which held its annual meeting in March, and saw both the Chairman and President receive approximately 78% support, a very low figure for the Japanese market.
Glass Lewis is not advocating an approach that focuses so heavily on ROE. While we believe that ROE is a valuable metric in evaluating the effectiveness of an issuer’s ability to generate profits from the capital provided by its shareholders, Glass Lewis questions whether ROE should be the sole metric relied upon when reviewing a company’s overall performance.
While we recognize the importance of ROE in evaluating a company’s performance and profitability, we are concerned that ROE on its own may force management to focus solely on a single target. We believe that multiple metrics and goals are ideal in gauging the overall profitability and financial position of the company.
Furthermore, some critics of the singular focus on ROE point to the ability of companies to manipulate this statistic, often through changes in the capital structure and/or share repurchases. As a result, ROE may not adequately – or completely – represent the performance of the Company.
While investors should welcome the new changes we discussed above, we also recognize that there is much room for further improvement in Japanese corporate governance practices. We should keep a close eye on what happens in the 2015 Japanese proxy season, as it may represent the beginning of a new age of corporate governance in Japan.