Select a country other than the UK, identify and describe the main components of its

governance environment, and discuss (using relevant academic research) the effectiveness

of these arrangements in seeking to ensure the protection of owners' interests.

‘Corporate Governance has become one of the most commonly used phrases in the current

global business vocabulary’ as stated in Solomon J. & Solomon A. (2005, p.11).

‘Traditionally defined as the ways in which a firm safeguards the interests of its financiers

(investors, lenders, and creditors). The modern definition calls it the framework of rules and

practices by which a board of directors ensures accountability, fairness and transparency in

the firm's relationship with all its stakeholders’, according to the business dictionary online

(2010). Therefore, at a micro level, ‘this involves actions that reconcile the need to protect

the downside risk to shareholders (that is, accountability of managers) as well as to

encourage managers to take risks to increase shareholder value (that is, encourage

managers to act entrepreneurially)’ as claimed by Keasey and Wright (1993, p.2). Whereas

at a macro level, as suggested by Greenspan (2002, p.1), ‘it has evolved to more effectively

promote the allocation of the nation's savings to its most productive use’. However, different

definitions are applied depending on which country is being considered (Solomon J. &

Solomon A. 2005, p.12). Therefore, we decided to critically study the corporate governance

environment somewhere other than the UK, in our case Japan. In order to do that we

highlighted what we believed to be the main topic areas; ownership structure, the system of

board of directors and auditors, remuneration and takeovers.

From 1985 to 1989 Japan was in its economic bubble, whereby share and land prices

increased sharply and because of this, banks were confident in loaning large amounts of

money towards this land. However, ‘the powers of the main bank have in general diminished

in Japan, since many banks fell into crisis after the collapse of the ‘bubble economy’’

(Demise, 2006, p.60), which led to falling share prices and devaluation of the land and as a

consequence shareholders and landowners lost fortunes, which meant they were unable to

1
repay their loans, leaving banks with large non-performing loans and as a result the

Japanese economy became stagnant. ‘Improving Corporate Governance was then seen as

a necessary step in the process of regaining confidence in the Japanese economy and in

stock market, and in attracting foreign direct investment to help regenerate growth in

companies’, according to Mallin (2009, p.282).

To begin with, ownership structure, according to the online Encyclopedia of Corporate

Governance (2010), ‘is defined by the distribution of equity regarding the voting rights and

capital but also by the equity owners’ identity. These structures have a key role in corporate

governance as they determine the incentives of managers and consequently the economic

efficiency of the firms they manage’. When considering the topic of ownership structure

could be useful to concentrate on three parts of company ownership and those are the

‘managerial ownership’, ‘the extent of ownership dispersion (block holders)’ and ‘the role of

institutional shareholders’. Generally in small businesses the same person holds both the

owner and the managerial role, which consequently eliminates problems of conflicting

interests. However, as companies grow in terms of size and complexity, the relationship

between owner and management becomes more inefficient and thus the role of

management needs to be delegated to one or more people other than the owner. Taking

that kind of action though, the possibility of agency problems can occur.

In the case of Japan, according to Morck, Nakamura & Shivdasani (2000, p.1), banks seem

to have a significant corporate governance role in the nonfinancial corporations and this is

being supported by the fact that equity ownership by banks has been ubiquitous for most of

Japan’s modern history. Bank equity ownership was first introduced back to Pre-war Japan,

‘when powerful Meiji families ran large banks that served as financial command centres of

closely held family corporate groups called zaibatsu’ (Morck, Nakamura & Shivdasani, 2000,

p.1), which are usually referred to as ‘main banks’. During the following two decades, after

the war, Japanese banks, in many cases, took equity stakes in firms that belonged to their

2
zaibatsu. Banks also placed large number of their own shares together with that of firms

within their zaibatsu and other former zaibatsu firms. ‘As a result, many large Japanese firms

are now members of corporate groups called financial keiretsu, characterized by a complex

web of intercorporate ownership centred around banks’ (Morck, Nakamura & Shivdasani,

2000, p.4). Other Japanese companies formed themselves into similar corporate groups

named ‘industrial keiretsu’ which are spread around large industrial firms. Main banks also

own blocks of the ‘Industrial keiretsu’ firms’ equity as in the case of the ‘keiretsu’ firms.

This intercorporate ownership structure, with banks as the central entity in many of the

groups, lead to an ‘industrial structure’ where banks and companies that they lend money to,

have a special relationship. ‘The main bank plays a lead role in consortia that raise capital

for the firm, acts as a monitor, and in cases of financial distress, serves as a guarantor for

other creditors’ (Morck, Nakamura & Shivdasani, 2000, p.2). Kaplan (1994), Kaplan and

Minton (1994), Kang and Shivdasani (1995), and Morck and Nakamura (1999), as cited in

Morck, Nakamura, Shivdasani. (2000, p.2), also state that main banks have a significant

corporate governance role as they appoint their employees to the boards of financially

troubled client firms. In addition, according to Mallin (2010, p.283), banks also buy shares

within the companies in order to firm up their relationship with them. However, according to

Morck, Nakamura & Shivdasani (2000, p.6), the interests of the banks often conflict with

those of the shareholders’ and as the number of shares they own gives them voice in

corporate governance, ‘they could lower value for public shareholders’. However, important

regulatory changes were noted, for example, before 1977 Japanese banks were allowed to

hold less than 10% of a firm’s outstanding equity. Concerns that banks would gain excessive

control over corporations, led in a decision from the Japanese Anti-Monopoly Ac in the year

of 1977 to lower the limit for stock ownership by individual banks to 5% (Morck, Nakamura &

Shivdasani, 2000, p.4).

3
Nevertheless, the above indications are not consistent with those of Solomon J. & Solomon

A. (2005), those of Nitta (2008) or those of Mallin (2010). Specifically, Solomon J. &

Solomon A. (2005) claim that Japan’s corporate governance system which was traditionally

dominated by banks, now is giving its place to a more ‘market-oriented’ system as ‘a series

of aggressive liquidations of banks holdings in Japanese companies is breaking the close

ties that banks and companies have traditionally enjoyed in Japan’. Additionally, they state

that institutional investors now have in their hands up to three quarters of the equity market

in Japan, which is similar to the UK’s ownership structure. At the same time the corporate

governance system ‘is characterized by concentration of ownership rather than wide

dispersion’ (Solomon J. & Solomon A., 2005, p.173) and from that we can assume that the

agency problems linked with this ownership model are less prominent. Nitta (2008) also

asserts that the equity capital of the firms is most commonly owned by institutional investors

and that a decline at the degree of 7% in cross-shareholding is noted. Moreover, Nitta (2008,

p.3) states that ‘insider ownership’ is increased from 6% to 11% from 1996 to 2006 showing

that is not only a few of Japan’s major firms that are family-controlled. Similarly to Solomon

& Solomon (2005), Mallin (2010) indicates that banks do not play any important part like they

used to do in the past. Nowadays they are replaced with ‘better structured boards, more

effective company auditors and, in some occasions, more active shareholders’ (Mallin, 2010,

p.287).

Finally, corporate block holders are significant in Japan as equity ownership by them is

positively related to the firm value. There are clear evidence in Kaplan & Minton (1994),

showing that corporate block holders have a key role in monitoring any changes concerning

the board of directors. However, there are no evidence of ‘nonmonotonicity’ in the relation

between firm value and corporate block holdings.

In terms of the Board of Directors this ‘is the highest management body responsible for

overseeing company business and making decisions on the way business is conducted’

4
according to Japan’s commercial code (Sano, 2001, p.4). Japanese Corporate Governance

is a relationship orientated system with very few outside directors; in fact compared to the

West Japanese boards used to exceed 30 members but nowadays typically consist of 21

inside members. In 1951, Commercial Code was revised and claimed the board members

were not to be ‘owners of a company but representatives of the interests of the firm i.e.

employees. Persons eligible to be board members are senior employees who have been in

the company for many years’ (Gugler, 2001, p.143). However, this Code has been re-revised

in 2003 and now ‘enables Japanese companies to introduce a board committee system and

abolish the auditor system. The board committee system is composed of the audit

committee, the nominating committee and the remuneration committee, and the majority of

the members of each committee is made up of directors outside the company’ (Demise,

2006, p.59). In 2002, the revised version of the Commercial Law was enforced and the

‘large Japanese companies came to be able to choose between the company with

committees board model (the fourth new type) and the traditional corporate auditor system

(the first, second or third traditional type)’ (Hirata, 2004, p.33), as shown below:

Figure 1 The Traditional Type with the Executive Committee

SHAREHOLDER’S MEETING

electing electing

Board of Directors Board of corporate Auditors

electing
auditing reporting electing

Representative
Director (CEO) Independent Public
Executive Director accountant

5
‘NOTE: Board of Directors must be composed of more than 3 directors. Board of corporate

auditors must consist of more than 3 auditors. More than 1 person of the member has to be

outside auditor. However, since the shareholder’s meeting in 2006 more than half of the

member must be outside auditors.’ (Hirata, 2004, p.34)

Board of directors must be composed of no more than 3 directors, who are elected at the

shareholder’s meeting. Board of corporate auditors, which is called ‘kansayakukai’ is also

elected at the shareholder’s meeting and must consist of at least 1 person being an outside

auditor. ‘However, since the shareholder’s meeting in 2006 more than half of the members

must be outside auditors’ (Hirata, 2004, p.34), and their job is to monitor and report back at

the shareholder’s meeting.

Figure 2 The Traditional Type with the Executive Officer

SHAREHOLDER’S MEETING

electing electing

Board of Directors
Board of corporate
Auditors
auditing

reporting electing

auditing auditing

electing supervising reporting

Independent Public
Representative Director Accountant
(CEO)

Executive Officer

6
‘NOTE: Board of directors must be composed of more than 3 directors. Board of corporate

auditors must consist of more than 3 auditors. More than 1 person of the member must be

outside auditor. However, since the shareholder’s meeting in 2006 more than half of the

member must be outside auditors.’ (Hirata, 2004, p.35)

Figure 3 The traditional type with the Committee for disposing or Taking Over the important

Property

SHAREHOLDER’S MEETING

electing electing

Board of Directors Board of Corporate Auditors

auditing

electing
Committee for
Disposing or Taking auditing reporting
electing
Over Important
Property
Independent
Public Accountant

Representative Director
(CEO)

Executive Director

‘NOTE: Board of directors must be composed of more than 3 directors. Committee for

disposing or taking over the important property must consist of more than 3 directors. Board

of corporate auditors must consist of more than 3 auditors. More than 1 person of the

7
member must be outside auditor. However, since the shareholder’s meeting 2006 more than

half of the member must be outside auditor.’ (Hirata, 2004, p.35)

Figure 4 The New Type with Three Committees and the Executive Officer

SHAREHOLDER’S MEETING

electing

Board of Directors

auditing

Audit committee reporting

Nominating Committee
electing

Compensation Committee

Electing supervising reporting

auditing auditing
Representative Officer (CEO)

Executive Officer Independent Public

Accountant

8
‘NOTE: Board of directors must be composed of more than 3 directors. Audit committee,

nominating committee, and compensation committee must consist of more than 3 directors.

More than half of the member must be outside directors.’ (Hirata, 2004, p.36)

The new type consists of three committees, which are ‘audit committee’, ‘nominating

committee’ and ‘compensation committee’, with half of the members from an external

source, including more than 3 directors. A prime example of a company that has

implemented this is Sony, who set up these three committees according to Nikkei Weekly,

March 1998, and ‘Notice to Shareholders on the Results of the Shareholders Meeting’, 29

June 1999, reported in Ballon and Matsuzaki (2000,p.39 cited by Gugler, 2001). It was

stated that Sony ‘reduced its directors to one-third (from 38 to 10) and introduced 3 outside

directors’ (Gugler, 2001, p.143), 2 of which are said to be U.S. citizens (Sano, 2001).

However, they believe that outside directors should never outnumber inside directors, so the

reduction in numbers of board directors led to newly appointed part time corporate executive

officers (shikko yakuin). It was suggested by Monks and Minow (2004, p.318 cited by

Demise, 2006, p.60) that this was an ‘attempt to change the board from an honorific body to

a genuine decision-making body that could offer strategic input and oversight’ (Demise,

2006, p.60). This innovated structure was shortly followed in 1999 by Hitachi, Softbank and

Hoya a famous lens maker in 2001.

However not all companies followed this, including Toyota, Canon, Matsushita Electronics

(more known as Panasonic Corporation) and Honda. They thought it was ‘important to

enrich the content of the first or the second traditional type’ (Hirata, 2004, p.37). In fact

Honda decided to keep 36 board members including 1 outside director and decided to follow

the traditional type (figure 3) ‘in order to demonstrate her mobility in making decision about

the important items on the investment list’(Hirata, 2004, p.37). The compliance committee

was then set up, as well as the 12 inside directors of the committee. On the other hand

Toyota did reduce the board of directors ‘from 58 persons to 27 who are all internal directors.

9
The reason why Toyota did not appointed any outside director is that every director must be

well versed in the actual work. 39 executive officers were newly appointed. 15 senior

managing directors and 39 executive officers are jointly responsible for the

execution.’(Hirata, 2004, p.37).

‘One of the difficulties in analyzing executive compensation in Japan is that companies do

not disclose the exact amount of each individual director’s remuneration. Neither company

law nor stock market listing rules require companies to disclose such information’(Abe,

Gaston & Kubo, 2004, p.382) However there is a requirement for Japanese corporations ‘to

report total salary and bonuses earned by all directors’ (Kato & Kubo, 2003, p.1). This is

because financial statements in Japan are used for tax purposes, unlike U.S., which is why

‘companies have greater incentives than U.S. companies to take deductions that reduce the

income reported of financial statements’ (Kaplan, 1994, p. 515), these statements are

released on March at the end of fiscal year in Japan. An existing research (Kaplan, 1994)

suggests that there is a positive relationship between Japanese top executive’s

remuneration, stock performance and the firm’s earnings. In addition Abe, Gatson and Kubo

(2005) suggest that sales growth is less important for the executive’s pay. However, all this

variables are insignificant for cash compensation per director, when negative pretax income

and changes in pretax income are present (Kaplan, 1994).

Executives pay in Japan are divided in two forms – direct salary and performance related

bonuses. (Abe, Gaston and Kubo, 2005). At the same time ‘large fraction of their salary is

paid as wage payments for employees and is not reported as the salary and bonus of all

directors in corporate proxy statements.’(Kato & Kubo, 2003, p.2). One of the most important

roles in Japanese wage system, which is a form of ‘profit sharing’ and serves to maintain

employment levels, is played by bonuses. In the case of directors these are much more

flexible than those of employees (Abe, Gaston & Kubo, 2005). There have been cases in the

recession, whereby instead of laying off workers bonuses or pays have been reduced e.g.

10
Japan Airlines ‘has agreed to a 5% pay cut and reduced allowances from the beginning of

the financial year. Under the agreement, there will be no pay raises or bonuses in 2010/11.’

To sum up the remuneration in Japan is much lower than in U.S. or Europe. ‘Kato and

Rockel find that Japanese CEOs earn on average $200,000 compared to almost $700,000

for U.S. CEOs’ (Kaplan, 1994, p.533)

With regards to auditors, the Japanese Code of Kansayaku has existed since World War II,

however, ‘ammendments to the Commercial Code in 1950 reduced the power and

responsibility of auditors. The system took its current form through amendments to the code

in 1974, 1981, 1993 and 2001, all of which extensively strenghthed the power and

independence of corporate auditors’ (Demise, 2006, p. 61). Furthermore, in February 2004 it

was reassessed again 'in order to respond to changes in the domestic and international

environments, and to clarify the roles and duties currently expected of Kansayaku' (Best

Practice of Corporate Auditor, 2007, p.1), and as a result in May 2006 the Kaishahou

Companies Act to Japan was put into practice. This Companies Act was to be used by all

large-scale businesses ‘which have a legal capital of ¥500 million or more or total balance-

sheet liabilities of ¥20 billion or more’ (Demise, 2006, p.62)’ and those that were listed

companies, whereby their shares can be traded within the stock exchange. It is suggested

that there are ‘approximately 12, 000 of these large companies today’ (About Corporate

Auditor, 2007, p.1). These companies must also create a board of Kansayaku ("kansayaku-

kai"), which is to be elected at a shareholders meeting, this must be ‘composed of at least

three corporate auditors, at least one of whom must be full-time’ (Demise, 2006,p. 62) and

half of which must be directors outside the company. These kansayuku auditors are to

serve for ‘a four year term, as compared to two years for directors’ (About Corporate Auditor,

2007, p.2). However, it must be noted that the ‘kansayuki-kai must be a separate body from

the board of directors’ and ‘the companies act provides grounds for the disqualification of

kansayaku and directors, such as not permitting an auditor to serve concurrently as a

director, officer or employee of the company or its subsidiaries’ (About Corporate Auditor,

11
2007, p.2). Their individual role is to '"audit" the activities of directors' (About Corporate

Auditor, 2007, p.1). Within the audit there are two main parts, eg. the "business audit" and

the "financial audit". ‘A business audit is an assessment of whether or not the directors are

correctly observing applicable laws and the company’s charter provisions while managing

the company, and is commonly referred to as a “compliance audit”’ (About Corporate

Auditor, 2007, p.1). However, ‘it is generally understood that this does not include a check

on the appropriateness of a director’s decision- making or activities (sometimes referred to

as an “appropriateness audit”)’ (About Corporate Auditor, 2007, p.2). Furthermore, because

the ‘kansayaku owes a duty of care to the company’ this ‘business audit must include a

check on whether or not there have been any breaches of this duty of care’ and

consequently ‘kansayuku must examine the directors’ business judgments from this

perspective’ (About Corporate Auditor, 2007, p.2). The ‘financial audit is an audit of financial

statements’ and therefore ‘must be conducted before the annual shareholders meeting’

(Demise, 2006, p.62), preferably 2 weeks beforehand, which is different to that required by

the Securities and Exchange Act. In addition to this, corporate auditors are also subjected to

audit ‘consolidated financial statements’ and the results are to be reported at the annual

shareholders meeting (About Corporate Auditor, 2007, p.1). The kansayaku corporate

auditors are ‘given various powers and legal rights in order to carry out their duties’ (About

Corporate Auditor, 2007, p.3). These are:

1. ‘The right to examine the operations and assests of the company at any time’ and in

certain cases the same report for any of the company’s subsidiaries. Therefore, ‘if a

director is aware of the possibility of significant damage occurring to the company, he

or she must report this to kansayaku-kai’ (About Corporate Auditor, 2007, p.3).

2. ‘All kansayaku members must attend all board of directors meetings and each auditor

is entitled to express opinions as necessary with a view to preventing the board of

12
 directors from making illegal or significantly inappropriate decisions affecting the

company’ (About Corporate Auditor, 2007, p.3).

3. In litigation, the company is represented in court by the kansayaku therefore ‘it is the

kansayaku who makes decisions about whether the company will sue a director’

(About Corporate Auditor, 2007, p.3).

4. Finally, as mentioned previously, ‘Kansayaku checks the appropriateness of a

summary of the process and of the results of the financial auditor’s auditing’.

Furthermore, ‘if the financial auditor uncovers an inappropriate act or violation of the

law or the company’s charter provisions in connection with the directors’ activities, the

financial auditor must report it to kansayaku-kai’ (About Corporate Auditor, 2007, p.4).

Takeover is the ‘assumption of control of another (usually smaller) firm through purchase of

51 percent or more of its voting shares or stock’, according to the business dictionary online

(2010). Corporate governance of Japan has been spared from takeovers until recently, when

takeovers gained importance and developed drastically. For example, ‘in 2006, Japanese

companies bought 2175 Japanese companies (in-in) and 412 foreign companies(in-out);

foreign companies bought 171 Japanese companies (out-in); and foreign companies

acquired by Japanese companies bought 17 foreign companies(out-out)’ (Suzuki, Baker &

MCKenzie, p. 1). However, hostile takeovers have become a threat in Japan and many

people point to a U.S. style ‘poison pill’ tactic, according to Tsuru (2005), which is a defence

method to safe guard against negative takeover bids. An example of an hostile takeover in

Japan was that between Livedoor Co., Ltd. (Livedoor) and Fuji Television Network

Inc.’(Kotaro, 2005) for Nippon Broadcasting System (NBS), which as a result placed the

milestone in the history of takeovers in Japan (Tsuru, 2005). However, hostile takeovers

should not be always assumed as negative as it can be seen as an incentive to increase

13
corporate value. Nevertheless ‘if Japanese companies are to enter a new frontier, they must

proactively utilize the takeover mechanism as a means to break from the past and realize

true restructuring, rather than trying to maintain amicable relationships with stakeholders’

(Tsuru, 2005).

Therefore, to conclude, it is apparent that the corporate governance environment is vastly

changing in Japan in recent years compared to the past. There are also clear influences

from Anglo-American systems, which came into practice with the merging and

internationalization of the Japanese market. One of the pioneers in the adaptation and

modernization of Japanese Corporate Governance is by no doubt Sony (looked at

previously) and as a result many other companies have followed with their own adapted

structure, for example, the Board structure of Nissan after merging with Renault in 2000.

Nevertheless, the experts and researchers of Japanese Corporate Governance believe that

Japan will never completely assimilate that of the Anglo-American structure due to

Commercial Code, Law and Regulations.

However, after recent changes in the Japanese government and the global recession, Japan

and it’s government are trying to make significant changes in their Codes and Laws, which

will hopefully force Japanese companies, who have not done so already, to reconsider and

develop new corporate governance system. It is suggested according to Reuters (2009) that

a new law is going to be implemented whereby one third of a company’s board must be

composed of independent directors. In addition, they are also pushing forward the

representation of the employees in the auditing board. Furthermore, details of the

remuneration (including bonuses and stock) must be disclosed; when they exceed 100

million yen. As a result we can look forward to the new upcoming improved Japanese

corporate governance system, which will disclose more information than ever before and

make it easier to understand and compare to those systems of the UK and U.S.

14
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