Key points

  • The 2018 revision was finalized on June 1, 2018. Principle 5.2 added the requirement to accurately identify the company’s cost of capital, formally making it part of listed companies’ business planning and accountability.
  • The role and disclosure standards for boards of directors have also been raised regarding cross-shareholdings (Principle 1.4), CEO succession planning (Supplementary Principle 4.1.3), and corporate pensions (Principle 2.6).
  • The “Guidelines for Investor-Company Dialogue”, which were released at the same time, are annexes to both codes and set out important matters that companies and institutional investors should discuss.

From “form” to “substance”

The Expert Council, which was responsible for developing the 2015 Code, was subsequently succeeded by the Stewardship Code and Corporate Governance Code Follow-up Council, which is jointly secretariatized by the Financial Services Agency and the Tokyo Stock Exchange. What is important here is that the corporate governance code for companies and the stewardship code for investors are now being examined not as separate systems, but as a set of mechanisms that interact with each other.

After the introduction of the 2015 version, the appointment of independent outside directors and the submission of corporate governance reports became widely established. On the other hand, questions remain as to whether the substance of management, such as board discussions, capital allocation, and the appointment and dismissal of the CEO, has changed. At the time, the Financial Services Agency advocated the idea of deepening corporate governance reform “from form to substance.”

The 2018 revision reflected this awareness in the code text. Rather than adding many new items, they raised the required standards for issues that are directly linked to corporate value, such as cost of capital, cross-shareholdings, CEO succession planning, and corporate pensions.

Column: Why dialogue guidelines were necessary in 2018 The principles of the code alone do not tell us what companies and investors should discuss in actual meetings. Therefore, the Financial Services Agency has organized management strategies, capital policies, appointment and dismissal of CEOs, functions of the board of directors, cross-shareholdings, corporate pensions, and other matters to be prioritized through dialogue. The code indicates the principles of conduct for both companies and investors, and the dialogue guidelines play a role in linking discussions between the two parties.

Four points at the center of the revision

The following four points had a particularly large practical impact in the 2018 revision.

issue 2015 edition What has changed in the 2018 edition
Capital cost Principle 5.2 required an explanation of business strategy and business plans, but the term “cost of capital” was not included. Revised Principle 5.2. The revision required companies to understand their cost of capital accurately and explain their profit plans, capital policies, targets for profitability and capital efficiency, business portfolio, and specific plans for allocating management resources.
Strategic holdings Principle 1.4 required disclosure of the holding policy and verification of its rationality by the board of directors. Reinforces principle 1.4. Required to disclose holding policies, including reduction policies, and to verify annually whether the benefits and risks of each individual stock are commensurate with the cost of capital. Supplementary Principle 1.4.1 stipulates that when a cross-shareholder proposes to sell, the sale must not be hindered by suggesting a reduction in transactions or otherwise.
CEO succession plan Supplementary Principle 4.1.3 touched on succession planning, but the board's involvement was only briefly described. Revised supplementary principle 4.1.3. Defined the ideal CEO image in light of management strategy, and clarified that the board of directors will take the initiative in supervising succession planning and candidate training.
Corporate pension There was no mention of corporate pensions. Principle 2.6 newly established. The revision called on sponsoring companies to provide support in terms of human resources and operations, such as the appointment and placement of specialized human resources, and to disclose their efforts so that corporate pensions can function as asset owners.

Of these, the cost of capital was the one that had the greatest impact on later system development. Since 2018, eligible listed companies have been required to demonstrate that they develop business plans based on an understanding of their cost of capital, or to explain why they have not done so. The Tokyo Stock Exchange announced in March 2023, “Measures to realize management that is conscious of cost of capital and stock prices,” is not a policy that suddenly started. This can be seen as a re-examination of the expectations expressed in Principle 5.2 to companies as more specific management issues.

Explanation required by Principle 5.2

Principle 5.2 of the 2018 edition calls for not only understanding the cost of capital, but also linking it to management decisions and explaining it in a way that shareholders can understand.

"When formulating and announcing business strategies and business plans, companies should accurately understand their company's cost of capital, and then present basic policies for profit plans and capital policies, as well as goals related to profitability, capital efficiency, etc., and provide clear explanations in terms and logic that are easy for shareholders to understand about what they will do in terms of reviewing their business portfolio and allocating management resources, including capital investment, research and development investment, human resources investment, etc., in order to achieve these goals."

  • Corporate Governance Code (2018 Edition) Principle 5.2

The question here is not just to provide a single figure for the cost of capital. There is a need to explain how profit targets and capital policies are determined, and how they are reflected in business portfolios, capital investments, research and development, and human resources investments.

The same cost of capital concept was also used as a criterion for cross-shareholdings.

“Every year, the board of directors should specifically examine each cross-shareholding to determine whether the purpose of holding it is appropriate and whether the benefits and risks associated with holding it are commensurate with the cost of capital, verify whether the holding is appropriate, and disclose the details of such verification.”

  • Corporate Governance Code (2018 Edition) Principle 1.4

As a result, it has become difficult to explain cross-shareholdings solely by the general theory that they are held because they are necessary to maintain business relationships. The board of directors is required to confirm the benefits and risks of holding each stock for each stock, and to make judgments that are conscious of comparisons with what it would be like to allocate that capital elsewhere.

“Investor-Company Dialogue Guidelines”

The “Investor-Company Dialogue Guidelines” published in June 2018 are positioned as an annex to the Corporate Governance Code and the Stewardship Code. Although the guidelines themselves are not subject to a "comply or explain" policy, they indicate important matters that companies and investors should discuss in order to effectively implement both codes.

The main points at issue are as follows.

  • Management decisions in response to changes in the business environment
  • Investment strategy and financial management
  • CEO selection/dismissal/development and board functions
  • Cross-shareholdings
  • Corporate pension as an asset owner

By having guidelines, it is now possible to not only check whether the principles are being followed, but also to delve into how those principles are functioning in management through dialogue. For example, in the case of cost of capital, the issue is not just whether there is a calculated value, but also how that level is used for investment decisions and business exits.

Independence of the Board of Directors and the Nomination and Compensation Committee

The 2018 revision also raised expectations regarding board composition. Principle 4.8 maintains the existing standard of appointing at least two independent outside directors, while requiring companies to disclose their policy of appointing one-third or more of independent outside directors if deemed necessary based on industry, size, business characteristics, organizational design, etc.

Supplementary Principle 4.10.1 requires companies whose boards of directors do not have a majority of independent outside directors to establish a voluntary nomination committee, compensation committee, etc. whose main members are independent outside directors, and to obtain appropriate involvement and advice on important matters regarding nomination and compensation. This made it possible to create a system that increases the objectivity of CEO appointment and dismissal and executive compensation without changing the statutory institutional design.

Response status of listed companies

When the Tokyo Stock Exchange compiled corporate governance reports as of the end of December 2018, on the First Section, 18.1% of companies complied with all principles, and 85.3% of companies complied with more than 90% of all principles. Compared to the July 2017 tally, this is a decrease of 13.4 points and 7.7 points, respectively.

This should be interpreted as a result of the revisions raising the required standards and adding new items that require explanations, rather than a regression in companies' efforts. In particular, the compliance rate for Supplementary Principle 4.10.1 regarding voluntary nomination and compensation committees whose main members are independent outside directors was only 52.1%. It can be seen that the 2018 revisions have presented companies with issues that are difficult to resolve with formal responses.

Practical matters that IR personnel should keep in mind

  1. Link the description of the cost of capital to Principle 5.2. When presenting WACC, ROIC, and equity spread, do not simply introduce financial indicators, but also explain business strategy, capital policy, and management resource allocation.
  2. The decision-making process for cross-shareholdings will be organized for each stock. Align the reduction policy, annual review by the board of directors, and sales results for the current period. The standard phrase "maintaining business relationships" alone does not provide the explanation required by Principle 1.4.
  3. A succession plan should not be created just before a change occurs. Document the qualities required in a CEO, how to develop candidates, and the frequency of reviews by the nominating committee and board of directors during normal times.
  4. Include corporate pension management within the scope of IR explanation. Check with the relevant departments within your company regarding the company's pension management system, specialist human resources, approaches to asset management institutions, and conflict of interest management.
  5. Use the dialogue guidelines to prepare for the interview. Replace each item in the guidelines with questions that can be asked by investors and reflect them in advance briefing materials for CEOs and CFOs.

Source/reference materials

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