Corporate Governance and Corporate Responsibility in Japan and the United States
Sanford M. Jacoby (Professor, The Anderson School of UCLA)
Remarks for the Doshisha-UCLA Conference on Global Business in the 21st Century, Kyoto International Conference Centre, November 1, 2002
Five years ago, an American visitor speaking to a Japanese audience about corporate governance would have said the following things:
1. He would have noted that the US in the 1990s shifted from a stakeholder governance system to a shareholder governance system. And he would have said that the shift resulted in a booming U.S. economy and stock market.
2. He would have pointed to key governance features of the shareholder model. They include a small board of directors made up of independent outsiders and an executive compensation system resting heavily on stock options. He also would have praised the transparency of the U.S. system, especially its accounting standards.
3. Finally, he would have said that the cost of capital in the U.S. was low because shares were so widely held. By the end of the 1990s, almost every person in the US who had a little discretionary income was dabbling in the stock market. This was good—it meant that the US had an equity culture and cheap capital.
Turning his eyes to Japan, the U.S. visitor would have been highly critical of the Japanese corporate governance system. He would have said the following things:
1. He would have told Japanese executives that, if Japan wanted to end its economic stagnation, it would have to adopt a shareholder-sovereignty system.
2. To do this, Japan would need to change the philosophy behind corporate governance. Managers would have to stop thinking that their role was to balance the interests of various stakeholders such as banks, suppliers, customers, and employees. Instead, their sole responsibility was to shareholders. To make sure executives recognized this responsibility, companies would have to shrink corporate boards; bring more outsiders onto the board; hand out more stock options, and change the auditing system to conform to U.S. standards.
3. Finally, the U.S. visitor would have said that Japan needed an equity culture, with much greater share ownership by individuals.
I'm quite sure that, after the speech, a Japanese newspaper would have reprinted the remarks on its editorial page. Perhaps a U.S. investment company would have sent copies of the speech to Japanese government officials.
Now it's five years later. Isn't it interesting how things can change in a short period of time? The US economy is stagnant. Share prices are way down from their high. Scandal after scandal is reported in the press. What went wrong?
1. First, in retrospect, it was a mistake to have made the inference that the US enjoyed high equity prices and economic prosperity because of its corporate governance system. If the link between corporate governance and macroeconomic performance actually existed, one would expect countries with U.S.-style governance systems to have enjoyed similar prosperity. But neither Britain nor Canada –both of which have U.S.-style systems—performed especially well in the 1990s. The one major academic study to analyze this issue looked at a sample of countries over time and found that dispersion of share ownership—the key feature of shareholder governance--is NOT statistically related to a nation's per capita GDP.
2. Second, every corporate governance system has costs and benefits. It is simply not possible to design a perfect system. In the 1990s, we tended to focus a lot on the benefits of the U.S. approach. But we de-emphasized the costs. The biggest cost was first pointed out nearly seventy years ago by economist Adolph Berle: dispersed ownership means poor monitoring because individual investors do not have the time or ability to keep a close eye on management.. Many thought that institutional investors like mutual funds and pension plans would perform this role. But institutional investors—with a few exceptions—turned out to have the same kind of short-term horizons and bubble expectations as individual investors.
Given these monitoring problems, the board of directors is crucial. But recent events in the US have shown that small independent boards are often ineffectual. Most outside directors have little incentive to carefully scrutinize management, even if they own a little stock in the company they supervise. And if they are given a lot of stock, directors become reluctant to bite the hand that feeds them. Also, outside directors tend to lack expertise. A recent article in the NY Times reported on an accounting test given to corporate directors. Only 32 percent gave correct answers! Surely Doshisha or UCLA business students could do better! One of the questions asked directors to define "retained earnings." What percent do you think gave the right answer? Only 20 percent.
Another problem is the belief that issuing stock options will align managers to shareholders. It's a nice idea. But it too has flaws. Because boards are weak and lack expertise, executives have the power to influence their own compensation. They use that power to extract money from the corporation beyond what is needed to motivate them. For example, there is almost complete absence of indexing in the use of stock options. Options are awarded for general-market or industry effects rather than above-average performance. Also, executives can reload options so as to profit from share price volatility even when long-term share performance is flat.*1 And the repricing of underwater options removes downside risk.
Not surprising, then, that research shows that the highest-paid CEOs are from companies with two characteristics: 1) a large percentage of the directors have been picked by the CEO and 2) no shareholders hold stakes greater than five percent.
3. Finally, the idea that shareholder interests trump those of employees might have made sense in the old days, when employees were simply hired help. But today, the US economy is dominated by companies based on creative and technological skills. A company's intangible, intellectual capital is worth far more than the physical assets purchased with equity capital. Hence it's important for companies to retain talented employees and get them to develop company-specific skills. Investors would be better of if they acknowledged that employee loyalty is a key prop to competitiveness and to long-term value. But that insight gets lost when share price value is the sole criterion driving corporate decisions.
Will recent legislative reforms and SEC regulations remedy these problems? Yes, but only to a limited extent. Many of the solutions must come from corporations themselves. Right now, some US companies are in the midst of a shift away from the shareholder ethos of the 1990s to a new and different approach. Gradually, the distortions induced by the equity boom are fading away. The US has entered its own post-bubble phase, which social responsibility and ethics very likely will be more important.
What does all this mean for Japan? Just as it was wrong to attribute US prosperity to its corporate governance, so would it be a mistake to blame Japanese stagnation on its own approach to governance. Japan had the same governance system in the 1980s, when its economy was powerful, as in the 1990s, when it was not.
And just as the US system has its costs and benefits, the same is true of Japan's:
On the positive side, Japanese corporate governance has some commendable features. Directors who come from inside the company well understand the company's marketing, accounting, and technological issues. They have been groomed for years for top positions. The selection process inside Japanese corporations is based on experience and loyalty, not on charisma or celebrity status. When corporate scandals occur in Japan, it is usually because an executive has broken the law to benefit the company, rather than enrich himself personally.
Another positive feature is the philosophy that the corporation is a social institution, with responsibilities not only to shareholders but to employees, customers, and the wider society. In the 1990s, some investors—and some companies--rejected this philosophy for being naïve or an excuse for poor performance. But now we are beginning to appreciate that social responsibility and ethical behavior can promote long-term corporate value, whereas the lack of ethics and responsibility can destroy value.
Part of the stakeholder ethos is the idea that employees are investors, who have substantial human capital holdings in the corporation. Employees also own substantial amounts of company stock. In recent years the employee-stakeholder idea was viewed as naïve. But the stakeholder ethos is a way to sustain employee loyalty and skill. It keeps the shareholder in perspective, and in so doing keeps corporate finance from dominating executive decision-making in Japan. It is a way of maintaining compatibility between employee and shareholder interests.
On the negative side, Japanese corporations surely could improve the transparency of their activities and their accountability to shareholders. They also could give more weight to the interests of customers and bring them into the system as an important and valued stakeholder. And as for employees, they should be encouraged to speak up without fear of reprisal when they suspect corporate wrongdoing.
Also on the negative side is the banking and bankruptcy systems. Banks are propping up companies that are "brain dead". This is a waste of resources. Also, in the past, banks played an important monitoring role. It is not clear who or what will take the place of the main bank monitoring, especially as banks continue to unwind shares.
Until recently, many thought the answer lay in the US model, such things as smaller boards, the corporate officer system, outside directors, and stock options. But what works in the US may not work very well in Japan. And we now have reason to be skeptical that the US model works as well in the US as theorists claimed 5 years ago.
To improve corporate governance—in any country—is not an easy task. It requires solutions that fit the particularities of the national context. Companies—and the countries in which they are embedded—compete internationally by being different. The US economy is based on employee mobility and big-bang technological breakthroughs. The Japanese economy is based on technological learning, incremental innovation, and high-quality production. The Japanese corporate governance system must be changed without eroding the institutions that sustain Japan's comparative advantage.
Recent problems with US corporate governance should not be an excuse for inactivity or inertia in Japan. Those problems are a warning that Japanese companies need to put greater emphasis on ethics and on social responsibility. But in doing this, Japan has to find its own way. Finding your own way is always harder than following someone else. But it leads to better results in the long term.
*1 When an option is reloaded, the executive pays the exercise price by surrendering stock he already owns and for each share tendedred he receives a new option with the same expiration date as the original options. In this way, the executive locks in a portion of the gain but loses none of the future upside potential. This enhances the ability to profit from temporary price spikes in volatile situations. Reloading offers value to the executive but little obvious benefit to shareholders.