Summary

  • Postwar corporate governance was supported by five mechanisms: keiretsu, main banks, cross-shareholdings, boards of directors comprised mostly of internal employees, and lifetime employment.
  • At its peak in 1988, cross-shareholdings accounted for over 50% of TSE market capitalization, but by 2017 it had fallen below 10%. Bank shareholding also fell from over 20% to less than 5% over the same period.
  • After the main bank retreated, it became difficult to find an entity that would continuously supervise management. Two codes and GPIF stewardship activities have been put in place since 2014 to fill this gap.

Five mechanisms that supported postwar governance

In Japanese companies in the 1970s and 1980s, five systems functioned while complementing each other. It is difficult to get a complete picture of corporate governance at the time just by looking at each system separately.

  1. Keiretsu - A vertical trading network with horizontal corporate groups such as Mitsubishi, Mitsui, Sumitomo, Fuyo, Sanwa, and Daiichi Kangin Bank, and finished product manufacturers at the top. Horizontal keiretsu centered on city banks and general trading companies, and connected manufacturing industries, insurance companies, real estate companies, etc.
  2. Main bank system - This is a system in which the banks that are the main lenders also hold stocks, continuously monitor management during normal times, and participate in restructuring in times of management crisis. Masahiko Aoki theorized that this system supports Japanese companies' ability to adjust.
  3. Cross-shareholding -- A mechanism for mutually owning shares within a business relationship or corporate group. It played a role in securing stable shareholders and preventing changes in management rights and unsolicited acquisitions.
  4. Board of Directors and Audit & Supervisory Board System with Most Employees from within the company - Boards of directors often have 20 to 40 members, the majority of whom are executives who have been promoted within the company. As a statutory supervisory body, auditors and the board of auditors were established separately from the directors.
  5. Lifetime employment and seniority-based pay -- This became the basis for companies to be operated not just as an organization for shareholders, but as a community in which employees belong over the long term.

*Schematic diagram of cross-holding structure in horizontal series in the 1980s. Arrows indicate stock ownership relationships. The main bank played three roles simultaneously: shareholder, main lender, and de facto management monitor. *

What did this system achieve and who did it prioritize?

This corporate governance emphasized long-term coordination of stakeholders surrounding the company rather than maximizing shareholder returns. It was easy to share information within the corporate group, and the main bank was able to provide support and start restructuring at an early stage of business deterioration. Lifetime employment has also become a basis for investing in company-specific skills, with the assumption that employees will work for a company for a long time.

On the other hand, profits and surplus funds were prioritized for stable interest payments to lenders, employment and wages for employees, and long-term relationships with business partners. Dividends to shareholders and return on equity came after that. As a result, there was less pressure to increase ROE, and a structure was created that made it easier for management to distance themselves from dispersed general shareholders.

Column - Complete the auditor system in one step. Corporate auditors are statutory bodies that audit the execution of duties by directors, attend board meetings, and report to shareholders. However, they cannot participate in resolutions of the Board of Directors, appoint or dismiss executive officers, or decide on management strategies. In practice, there were many cases in which former internal executives or people from the main bank were appointed as auditors. Although the 2001 amendments to the Commercial Code stipulated that more than half of corporate auditors be outside corporate auditors and that their terms of office be four years, the authority structure that differs from that of directors continues to this day.

Gradual demolition, 1990-2014

After the stock price peaked at the end of 1989, the five mechanisms did not disappear all at once, but gradually weakened through three trends.

First wave - Bank capital deterioration (1990-2003). The decline in land prices and stock prices forced banks to dispose of non-performing loans and rebuild their capital. The sale of stock holdings progressed, and cross-holdings among affiliated companies fell from about 25% in 1981 to about 20% in 1999. Banks' holdings in listed stocks decreased from over 20% in the 1980s to less than 5% in 2014. The influence that banks had as shareholders and their ability to supervise management were simultaneously weakened.

Second wave - accounting and legal system reforms (1997-2008). Mark-to-market valuation was introduced for cross-shareholdings in fiscal 2001, making it easier to show the risk of price fluctuations associated with holdings in financial statements. The 2001 amendment to the Commercial Code strengthened the auditor system, and the 2002 amendment (enacted in April 2003) made it possible to choose a “company with committees,” which has nomination, audit, and compensation committees. However, its adoption has been slow, and as of the end of 2016, only about 70 of the approximately 3,800 listed companies had adopted it. The internal control reporting system based on the Financial Instruments and Exchange Act, so-called J-SOX, was applied from fiscal years beginning on or after April 1, 2008.

Third wave - increase in foreign investors (2003-2014). Foreign ownership of stocks listed on the Tokyo Stock Exchange rose from a low level in the 1980s to approximately 30% in 2014. While banks sold their shares, foreign investors began exercising their voting rights, participating in shareholder meetings, and questioning profitability and board independence. It was in 2017 that the ratio of cross-shareholdings fell below 10% of the total on the TSE.

By arranging the numbers, you can see the direction of change.

indicators 1988 peak 2014 (before Stewardship Code)
Cross-holding ratio (compared to TSE market capitalization) More than 50% Approximately 15% (and decreasing)
Bank ownership ratio of listed stocks More than 20% Less than 5%
Foreign ownership ratio of TSE-listed stocks Very little About 30%
Companies in the TOPIX500 that have one or more independent outside directors n/a Approx. 22%
Listed companies that are “conscious of the cost of capital” n/a About 40%
Listed companies disclosing cost of capital n/a Less than 10%

Monitoring gap

The problem is that after the old system weakened, no entity quickly emerged to take over its role. The main bank has reduced its shareholding and has withdrawn its involvement in management. However, the number of independent outside directors is still small; as of 2013, only about 22% of TOPIX 500 companies had appointed at least one director. Even though domestic institutional investors own stocks, the practice of actively engaging in dialogue with investee companies has not been sufficiently developed. Foreign investors sought dialogue, but there was no system in place to support this role within Japan.

The Ito report stated that the typical tenure of a CEO at the time was 4 to 6 years, and found it problematic that the timing of replacement was more likely to be decided based on seniority rather than performance. With a board of directors made up mostly of internal employees, auditors who do not have the right to elect or dismiss directors, and a shareholder structure with many stable shareholders, it has been difficult to create a system for replacing top management based on performance, except in cases of serious misconduct.

"Until the early 2010s, corporate governance in Japan was a system in which the oversight function was carried out by one institution - the main bank. However, that institution had largely withdrawn from that role, and no other actor was authorized to take its place." ―Curtis Milhaupt, On the (Fleeting) Existence of the Main Bank System and Other Japanese Economic Institutions (Columbia University School of Law)

The reforms since 2013 can be seen as institutional improvements to fill this void. The 2014 Stewardship Code required institutional investors to engage in constructive dialogue with the companies in which they invest. The 2015 Corporate Governance Code required the board of directors of listed companies to appoint independent outside directors. The Ito Report provided a common language for discussing capital cost and capital efficiency. GPIF took on the role of disseminating these ideas into practice through its investment managers.

From main bank to GPIF

The responsibility for management supervision did not immediately shift from the main bank to institutional investors. In between, there was a gap of about 15 years.

Main bank (1950s-1990s). In addition to being the primary lender, the bank also held approximately 3-5% of the equity in the investee companies and met regularly with management. Although they did not have legal veto power, they exerted significant influence over important business decisions through loans, stock ownership, and position within the corporate group.

Interregnum (1990-2014). Banks have reduced their equity holdings and loans, and have prioritized recovery and exit from non-performing debtors rather than long-term commitments. The appointment of independent outside directors has not yet become widespread, and dialogue with domestic institutional investors has been limited. Although foreign investors exercised their voting rights through overseas custodians, there were insufficient domestic systems to support continued lobbying of Japanese companies.

GPIF and outsourced asset managers (2014-present). GPIF announced its acceptance of the Japanese version of the Stewardship Code on May 30, 2014. Hiromichi Mizuno was appointed CIO in January 2015 and served until March 2020. GPIF outsources its domestic stocks to external management companies, so its efforts to reach out to companies are carried out through the outsourced management companies. GPIF's mechanism for assessing the stewardship activities of fiduciaries has provided a strong incentive to change dialogue and voting across the investment industry. By 2024, GPIF’s assets under management exceeded 240 trillion yen, an increase of 109 trillion yen since 2014.

The main banks of the 1980s and the institutional investors of the 2020s are very different in terms of organization and authority. Still, they all play a common role in continuing to ask, from outside the management team, “Are we making full use of the capital entrusted to us?”

Three structures that still remain

The pre-reform system has not completely disappeared. The following three factors will also affect IR practices in 2026.

  1. Cross-held shares remain. Although the market as a whole has shrunk, cross-shareholdings are still concentrated in insurance companies, megabanks, trading companies, etc. The 2021 Corporate Governance Code revision requires verification of the appropriateness of holding each individual stock and disclosure of the details.
  2. The majority are companies with a board of auditors. As of 2024, the majority of listed companies will not be companies with an audit and supervisory committee or companies with a nominating committee, etc., but companies with a board of auditors. In dialogue with foreign investors, it is necessary to explain the difference in authority between auditors and directors and the reasons for choosing the current institutional design.
  3. The practice of emphasizing internal promotion and seniority continues. Although lifetime employment itself is changing, there is still a strong tendency to select director candidates from within the company. The pool of outside director candidates is not wide enough, and there are only a limited number of cases in which management personnel move between different industries.

These issues will be revisited in themes 4 and 5, which deal with cross-shareholdings, listed subsidiaries, and board diversity.

Implications that IR personnel should keep in mind

  1. Look at shareholder composition over time. If the holding ratio of domestic financial institutions or business partner companies is high, check whether the holding constitutes cross-shareholdings and how it will affect the tradable-share ratio when sold.
  2. Be able to explain the performance of management supervision. List cases where management was replaced for business performance or strategic reasons, cases where the board of directors revised or rejected important matters, and the role played by independent outside directors.
  3. Explain the auditor system accurately in English. The official name is the "Audit & Supervisory Board," and auditors do not have voting rights on board resolutions. Be able to explain this difference in one sentence.
  4. Cross-shareholdings are explained for each stock. “Maintaining business relationships” alone is not enough. Compare the benefits, risks, and cost of capital of holding the shares, and concretely show the reduction policy.
  5. Follow trends in foreign ownership ratio. As the foreign ownership ratio increases, the issues raised in dialogue will change, such as capital efficiency, board independence, and cross-shareholdings. Manage based on long-term trends rather than single-year numbers.

Source/reference materials

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