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Legal and Regulatory Framework for Corporate Governance:

A Japanese Perspective

December 14, 2001

Hideki Kanda

Professor of Law

University of Tokyo

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Major Topics

• Basics– Where do laws and regulations matter?

• Four areas– (1) illegal activities and conflict of interest

transactions– (2) investor protection– (3) shareholder activism– (4) recent reforms of company law in Japan

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Basics (1)

• What is corporate governance?– (1) a mechanism for preventing and controlling

illegal activities (such as fraud, stealing and waste of assets) by managers, employees and others

– (2) a mechanism for enhancing company performance

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Basics (2)

• What laws and regulations matter and how?– Basic laws and regulations are important, such

as company law, insolvency law, securities regulation and criminal law.

– Laws and regulations must be enforced.– Laws and regulations are not everything, and

thus shape only part of the entire system of corporate governance.

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Four Topics

• (1) illegal activities and conflict of interest transactions

• (2) investor protection (capital market regulation)

• (3) shareholder activism

• (4) recent reforms of company law in Japan

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Topic 1: Illegal Activities and Conflict of Interest Transactions

• Japanese experience: two types of illegal activities

– illegal payment to disrupting shareholders at shareholders’ meetings

– insider trading

• Japanese response

– wrote special rules with criminal sanction

• Lesson

– we need an effective prosecution system and a reliable judicial system.

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Topic 1: Illegal Activities and Conflict of Interest Transactions - An Addition

• Role of company law– Role of the board– Role of shareholder derivative action

• Japanese experience– Shareholder derivative actions were effective in

some cases of illegal activities.

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Topic 2: Investor Protection- the problem -

• Any system does not function well unless accompanied by proper regulation and proper enforcement.

• The costs of regulation and enforcement are not zero.

• How to design and maintain effective regulation and enforcement is the key.

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Topic 2: Investor Protection- the problem (continued) -

• Imagine a world where there is one simple rule: “do not do bad things.”

• In this world, the cost of enforcement is prohibitively high.

• To reduce the cost of enforcement, there must be more specific rules. To write such rules is costly, and the optimal level is difficult to determine.

• For proper enforcement, there must be other legal infrastructures, such as a well-functioning judicial system.

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Topic 2: Problems of the Capital Market System

• In general, the capital market system is better than the bank system – but if the costs of regulation and enforcement are zero!

• Investors, not intermediaries, take investment risks.• Opportunities to defraud investors

• Relatively difficult to regulate, because there is no focal point?

• Misregulation leads to a disaster.

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Topic 2: Regulation of Capital Markets

• The need of three strong regulations– strong investor protection– strong watchdog or enforcer (“SEC”)– strong regulation of institutional investors

• Preparing and maintaining these three strong regulations are not costless.

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Regulation of Capital Markets (1)

• Strong investor protection– transparency and fairness– “mandatory disclosure” and “anti-fraud rules”

• Dealing with the collective action problems of bondholders– Trust Indenture Act of 1939 (U.S.)

• Broker-Dealer Regulation– conduct regulation and segregation rules– safety-net and capital regulation

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Regulation of Capital Markets (2)

• Strong enforcement– For disclosure, proper accounting rules and

proper auditing requirement must be provided.• A reliable CPA system must exist.

– Both for disclosure and anti-fraud, a strong enforcer (SEC) is necessary.

– The role of private litigation may be important.• A well-functioning judicial system must be

provided.• The class action system must be recognized.

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Regulation of Capital Markets (3)

• Strong regulation of institutional investors– The capital market system does not mean the

lack of financial intermediaries.– Intermediaries, such as mutual funds and

pension funds, are popular.– Strong fiduciary regulation on these

intermediaries is necessary.– Strong enforcement is necessary here, too.

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borrower investors

The Capital Market System:Basics

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borrower institutions investors

The Capital Market System:Reality

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Regulation of Capital Markets (4):The Japanese Framework

• a complex system of disclosure, accounting and auditing

• a unique two-board system: the board of directors and the board of auditors

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Japan: Two-Board System

board of directors board of auditors

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US and other countries: One board with committees

board of directors

audit committee compensation committee

nominating committee

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Japan: Practice (tradition)

• Life-time employment system• Bank-based finance• Mutual stockholdings

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Japan: Practice (tradition)implications

• Life-time employment system– Almost all directors and managers were former

employees.

• Bank-based finance– The main bank’s role was important.

• Mutual stockholdings– Shareholders were silent and hostile takeovers were

difficult.

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Japan: Practice (today): No.1

• Life-time employment system– Changing.. Outside directors are becoming popular,

though the change is gradual.

• Bank-based finance– The main bank’s role is disappearing.

• Mutual stockholdings– Melting..

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Japan: Practice (today): No.2

• A board of statutory auditors action resulted in the resignation of president of a listed company.

• There were hostile takeover attempts (not successful).

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Topic 3: Shareholder Activism

• Who are active shareholders?

– United States

• public pension funds

• unions

• individuals?

• private funds (e.g. mutual funds) are inactive shareholders

– Japan

• life insurance companies?

• other institutional shareholders?

• individuals?

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U.S.: What do Active Shareholders do?

• Formal actions– proxy fight– proposal– derivative action– other

• Informal actions– negotiation with management

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U.S.: Shareholder Proposals by Activists

• increase the number of independent directors on board

• eliminate poison pills or other defensive measures against hostile takeovers

• reduce executive compensation• ask for confidential voting

– For a survey of empirical studies, see Romano, Less is More: Making Institutional Investor Activism a Valuable Mechanism of Corporate Governance (working paper, 2001)

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Japan: Legal Framework

• proxy fight– difficult because of mail voting

• right to proposal• right to ask questions• shareholder derivative action

• action for invalidation of a resolution of the shareholders meeting

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Japan: Practice

• The life insurance industry complains low level of dividends at portfolio companies every year.

• proxy fights: none

• derivative actions: popular

• proposal right: popular, but mostly on social matters

• right to ask questions at the shareholders meeting: popular, but mostly on social matters

• other actions: action for invalidation of a resolution of the shareholders meeting is somewhat popular.

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Stated Purpose of Shareholder Activism

• U.S. institutions: enhancing shareholder value (=enhancing firm performance)– Unions may have other goals.– Individuals may have other goals.

• Japan: not clear, often social matters

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Topic 4: Company Law Reform in Japan

• Many reforms– Amendments in June 2001: Deregulation of share

repurchases– Amendments in November 2001: Deregulation of stock

options and recognition of electronic means in company law

– Amendments in December 2001: Liability limitation of directors and auditors and strengthening of the auditor system

– Expected amendments in 2002: Change in the board of directors and related matters

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Japan: Company Law Reform (1)

• A bill for amending Company Law (Commercial Code) was passed in the Diet on November 21, 2001. It deregulated the stock option system. Stock options can be issued to anyone. This is expected to be used as incentive mechanisms in the future.

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Japan: Company Law Reform (2)

• A bill for amending Company Law (Commercial Code) was passed in the Diet on December 5, 2001. It introduced the limitation on the liability of directors and statutory auditors, and strengthened the statutory auditor system.

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Japan: Company Law Reform (2)

• New statutory auditor rule– At least half of the members of the board of

auditors must be independent auditors (for all “large” companies).

– The definition of independence is stricter.

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Japan: Company Law Reform (2)

• Liability limitation will apply only when the director/auditor is not grossly negligent and will not apply in certain category of actions (such as illegal dividends).

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Japan: Company Law Reform (2)

• New rule on the liability of directors and statutory auditors (where applicable): Maximum amount of liability to the company:– Representative directors: 6 year amount of the annual

compensation

– Directors and statutory auditors: 4 year amount of the annual compensation

– Outside directors: 2 year amount of the annual compensation

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Japan: Company Law Reform (3)

• An exposure draft by the Ministry of Justice was published in April 2001 for public comments. It includes drastic changes (for all “large” companies) :– requiring at least one independent director on

board– choice between the statutory auditor system and

the system of a single board with the audit committee, the compensation committee and the nominating committee

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Tentative Conclusion

• Laws and regulations are important in corporate governance.– preventing illegal activities

– protecting minority shareholders from dominating shareholder's misbehavior

– protection of investors in capital markets

• Applying “rule of law” rather than “rule of person” in corporate governance will be an exciting challenge in Asia for the coming decades.