How Japan's Stewardship Code Works

For many years, institutional investors in Japan have been criticized for being too cozy with corporations. Combined with the webs of cross-share holdings that have tied up large chunks of shares among groups into management-friendly blocks, institutional investors were viewed as having passive policies that lead them to either blindly vote in line with management, or to simply not exercise their votes at all.

This meant that many managers could take actions that weren't in the best interest of shareholders (or even downright harmful to many of them), without the fear of repercussions or meaningful resistance.

To improve corporate governance, the Council of Experts Concerning the Japanese Version of the Stewardship Code, a group organized by the government's Financial Services Agency (FSA), published a document in February 2014 called "Principles for Responsible Institutional Investors <<Japan's Stewardship Code>>," the English version of which can be found here. The goal of this document was to lay out a framework that would "promote sustainable growth of companies through investment and dialogue." In other words, the government hoped to encourage the country's institutional investors to get more involved with the companies that they invest in, eventually leading to better-run, faster-growing companies.

Japan's stewardship code is aimed at getting "institutional investors to fulfill their fiduciary responsibilities, e.g. by promoting medium- to long-term growth of companies through engagements." But the language of the document is somewhat nuanced, or perhaps softer than what one might expect in the West. For example, though it explicitly encourages more engagement, it also "does not invite institutional investors to interfere with the finer points of managerial matters of investee companies."

Again, its focus is on the medium- to long-term horizon, with the goal of encouraging "sustainable growth." To effect this change, the code simply prescribes that institutional investors participate in "constructive engagement with investee companies" in order to arrive at a "common understanding." But for the most part, the specifics of what this all means is left out in what the document terms a principle's approach — investors are expected to conduct their actions in the spirit of the code, but are otherwise left to themselves to define the details of what that means.

That being said, the code does mandate that investors have a clear and public policy for stewardship, and that they regularly report to beneficiaries as to how that policy is being adhered to. For example, this may include reporting the results of how they voted on management proposals at shareholders meetings. They are also expected to have an "in-depth knowledge" of the businesses in which they have invested, so that they may actively participate in the code's prescribed "constructive engagement."

The Council of Experts on the Stewardship Code published a revised code in 2017, including new guidance related to the role of asset owners issuing mandates and monitoring their asset managers.

(For more, see Meeting Your Fiduciary Responsibility.)

On the one hand, forcing institutional investors into a framework where they must at least think about what constitutes good stewardship is probably a good thing. Taking that a step further by putting those views into writing and making them public is even better. Going even further — requiring them to regularly substantiate to beneficiaries that they have been adhering to their stated frameworks — is probably a pretty good idea too.

That being said, there are some issues here that are likely to dampen the impact of the above points. First and foremost, there's nothing legally binding about the stewardship code. Not only can institutional investors in Japan elect not to participate in the program at all, but even if they do they can also elect not to adhere to any of the code's seven provisions (or any of its sub-provisions for that matter) by simply explaining which provisions it does not plan to adhere to and why.

Furthermore, even where they do adhere to the code or any of its provisions, the language of the code is in most cases purposely vague. Institutional investors are more or less left to their own devices when figuring out the specifics.

Many observers from outside Japan, having read the English version of the stewardship code, may have similar sentiments to those mentioned above. But what one must always remember is that, regardless of what someone thinks about the construction of a plan or framework, true judgment of that plan should be reserved for whether it achieves its stated goals or not.

There are some reasons, however, for guarded optimism. First of all, the FSA keeps a list of all the institutions that have pledged to adhere to the code, a list which includes a link to each institutions' policy as mandated by the code (the list can be found in English here). In fact, as of Feb. 19, 2018 there have been 221 institutions in Japan that have signed up. This includes six trust banks, 22 insurance companies, 28 pension funds and 158 investment managers.

Predictably, many of the policies posted along with their pledges are as vague as the language of the code itself. But others are quite a bit more detailed, laying out specific views on topics like the need for outside directors on the board, director compensation, anti-takeover measures and issuance of new shares. Take for example this excerpt from Taiyo Pacific Partners:

In a June 2015 article, Nikkei Shimbun (Japan's leading daily business newspaper) also highlighted a few other examples of policies being either adopted or made public for the first time:

(translated)

• Nippon Seimei - Closely review the policy proposals of those companies that continue to have a ROE below five percent.
• Daiichi Seimei -  Oppose the reappointment of outside directors who fail to attend at least 50 percent of board meetings.
• Mitsubishi UFJ Trust Bank -  Demand a minimum ROE of five percent.
• Nomura Asset - Vote against management of poorly performing companies who have not also adopted outside directors on their boards.
• JPMorgan Asset - It is preferable to have multiple outside directors sitting on the board.

Plenty of evidence still points to a long road ahead. An article appearing in Nikkei from 2015 quotes an Institutional Shareholder Services (ISS) policy encouraging investors to oppose the reappointment of managers at firms where the average ROE over the past five years has been less than five percent. In that same article, data compiled by the Nikkei suggests that this equates to roughly 30 percent of the companies of the first section of the Tokyo Stock Exchange. In fact, those figures suggest an average ROE of just eight percent, and that only 31 percent of companies have ROE's in the double digits.

(For more, see: The Lost Decade: Lessons From Japan's Real Estate Crisis.)

As mentioned before, it is still a bit early to definitively determine whether Japan's new stewardship code will have any material impact on the investment environment in the country. But there are still reasons to be hopeful. The stewardship code was joined by the Corporate Governance Code in June 2015. While the governance code is also elective, it spells out in quite a bit more detail what it expects from corporations in the way of "good" governance. Furthermore, this governance code is shortly to be joined by the Tokyo Stock Exchange's own sister version, meaning many of its points could soon become obligatory for listed companies in the country.

Nevertheless, the true test will be time. It's much easier to adhere to lofty goals and targets when things are going well than when they are not. And this could well be true for both institutional investors and the corporations that they invest in.

Therefore, nothing may be known until the next downturn. Once profits start to fall and outside directors start to challenge management's plans, will they keep their posts or get booted? When management refuses to close down or sell underperforming business lines, will institutional investors finally make their voices heard? Or will it all go back to the way it was before, where corporations focused on size and sales instead of return on capital and profits, and where the only real institutional voices in the market were coming from those pesky foreigners.