Japan: landmark corporate governance reforms

May 2015 Japan: landmark corporate governance reforms Japan has seen landmark reforms in corporate governance during 2014 and 2015. On 26 February 2014, Japan s Financial Services Agency (FSA) released the final version of the Stewardship Code, 1 the first of its kind for Japan. On 5 March 2015, the FSA released the final version of the Corporate Governance Code (Governance Code), 2 based on the OECD Principles of Corporate Governance and reflecting elements of the UK Corporate Governance Code (notably the comply or explain principle). The Stewardship Code is already in force. On 13 May 2015, the Tokyo Stock Exchange (TSE) announced that it had finished revising its listing and related regulations to implement the Governance Code and that it would come into force on 1 June 2015. 3 This leaves limited time for listed companies to implement any necessary measures to comply with the Governance Code before Japan s traditional AGM season in June, although the TSE has put in place transitional arrangements for companies that cannot immediately comply. 4 This briefing provides an overview of the reforms the Governance Code and the Stewardship Code (together, the Codes) implement, including the background to and objectives of the reforms, and to whom and how they apply. The appendix summarises some of the main principles of each. Background to the reforms One of the higher profile elements of the structural reform piece (the third arrow ) of Abenomics (Prime Minister Shinzo Abe s economic revitalisation programme) has been the improvement of corporate governance. These reforms have been driven in large part by pressure from the foreign business community to address what it perceives as a weak corporate governance regime in Japan. This is illustrated by, for example, inefficient use of capital by Japanese companies (some large companies are sitting on considerable cash reserves) and a series of corporate governance scandals over several years (most infamously the Olympus scandal). For more information please contact: Junzaburo Kiuchi Partner T +81 3 3584 3142 E junzaburo.kiuchi@ Takeshi Nakao Partner T +81 3 3584 8332 E takeshi.nakao@ Edward Cole Partner T +81 33 5848 533 E edward.cole@ Peter Lawley Senior Associate T +44 20 7427 3662 E peter.lawley@ 1 An English translation of the Stewardship Code is available at: www.fsa.go.jp/en/refer/councils/stewardship/20140407/01.pdf 2 An English translation of the Governance Code is available at: www.jpx.co.jp/english/news/1020/b5b4pj000000jvxr-att/cgcode.pdf 3 See: www.jpx.co.jp/english/news/1020/20150511-02.html 4 The TSE has indicated that it will not view failure to fully comply immediately as a breach of the Governance Code if a listed company is not able to do so despite best efforts and it includes appropriate explanation of its plans and schedule for future compliance in its corporate governance report. The TSE has also indicated that it will allow more time for finalisation of corporate governance reports this year. In 2015, listed companies will have six months following their AGMs to prepare and submit their corporate governance reports. From 2016 they will need to do so swiftly. 1

Japan has made progress on corporate governance in the past, even relatively recently, but efforts to reform corporate governance in Japan have traditionally been met with strong opposition from the business community, particularly the country s most powerful business lobby keidanren (Japan Business Federation). As such, none of the previous reforms have been as significant as the introduction of the Codes. In 2002, for example, the Japanese Companies Act was amended to allow companies to optionally adopt a committee system corporate governance structure. While there were some high-profile adopters (eg Sony), this structure remains underused, most likely due to the requirement to appoint outside directors 5 (which, until now, has not applied to the traditional statutory auditor (kansayaku) corporate governance structure used by most companies). Similarly, in 2004 the TSE introduced the Principles of Corporate Governance for Listed Companies and then revised them in 2009. However, these are not binding. Listed companies only need to respect the Principles, and make efforts to enhance their corporate governance. 6 The Principles have not been wholeheartedly embraced. In contrast, the Governance Code has a broad scope and will be binding on listed companies on a comply or explain basis, as discussed below. The Stewardship Code applies on a voluntary basis but has already seen significant take-up. While it remains to be seen what impact the Codes will have working together in practice, on paper they represent a considerable step forward for Japanese corporate governance. Principle objectives of the Codes The Governance Code is stated to establish fundamental principles for effective corporate governance in listed companies in Japan. It defines corporate governance as a structure for transparent, fair, timely and decisive decision-making by companies, with due attention to the needs and perspectives of shareholders as well as customers, employees and local communities. The Governance Code seeks growth-oriented governance, and its primary purpose is to stimulate healthy corporate entrepreneurship, support sustainable corporate growth and increase corporate value over the mid- to long-term. The Stewardship Code sets out principles considered helpful for institutional investors in fulfilling their stewardship responsibilities with due regard to both their clients and their beneficiaries as well as to investee companies. The Stewardship Code defines stewardship responsibilities as the responsibilities of institutional investors to enhance the medium- to long-term investment return for their clients and beneficiaries by improving and fostering investee companies corporate value and sustainable growth through constructive engagement, or purposeful dialogue, based on in-depth knowledge of the companies and their business environment. The Codes are expressed to be two wheels of a cart with the combined goal of achieving effective corporate governance in Japan. The Governance Code asks companies to examine their corporate governance, in light of the aim and spirit of the Governance Code, and to act to address any identified issues, supported by purposeful dialogue with institutional investors based on the Stewardship Code. The Codes are expressed to be two wheels of a cart with the combined goal of achieving effective corporate governance in Japan 5 The Japanese Companies Act defines an outside director as a director who is not currently, and has not in the past been, an executive director, executive officer or employee (including a manager) of the relevant company or any of its subsidiaries. The Governance Code additionally provides for independent directors, which are outside directors who satisfy independence standards established by the board of a listed company taking into consideration the independence criteria set by securities exchanges (see Section 4 under Main principles of the Governance Code in the appendix below). 6 See Rule 445-3 of the TSE s securities listing regulations at: www.jpx.co.jp/english/rules-participants/rules/regulations/tvdivq0000001vyt-att/securities_listing_regulations_20140701.pdf 2

To whom do the Codes apply? The Governance Code will apply to all companies listed on securities exchanges in Japan, other than foreign companies. Companies listed on the first and second sections of the TSE will need to explain any non-compliance with the Governance Code in its entirety. Companies listed on the Mothers market (TSE s market for high-growth and emerging companies) and JASDAQ will only need to explain any non-compliance with the General Principles of the Governance Code. Compliance with the Stewardship Code is voluntary, but institutional investors that support the Stewardship Code and are prepared to accept it are expected to publicly disclose their intention to do so. Despite being voluntary, as of 12 March 2015, 184 institutional investors had disclosed their intention to accept the Stewardship Code. 7 Nearly every major Japanese institutional investor is on this list, including the Government Pension Investment Fund, as well as a number of large foreign institutional investors. How do the Codes apply? Both Codes adopt a principles-based approach and a comply or explain approach in their application. Both approaches are relatively novel in the Japanese market. A principles-based approach, rather than a rules-based approach, is intended to allow flexibility for listed companies (in the case of the Governance Code) and institutional investors (in the case of the Stewardship Code) to implement the Codes focusing on substance, rather than black letter rules, and in a manner suited to the specific conditions and situations that they face. Implementation could depend, for example, (in the case of the Governance Code) on the company s industry, size, business characteristics, company organisation and surrounding environment, or (in the case of the Stewardship Code) on the institutional investor s investment policies. The comply or explain approach in the Governance Code mirrors the approach in the UK Corporate Governance Code and is binding on listed companies. In other words, if a listed company finds, in view of its individual circumstances, that it is inappropriate to comply with specific principles of the Governance Code, it does not need to comply with those specific principles, but it must explain in its corporate governance report its reasons for not complying. Notably, the preamble to the Governance Code states explicitly that offering a superficial explanation using boilerplate expressions would be inconsistent with the concept of comply or explain. While the Stewardship Code only applies on a voluntary basis, those institutional investors that have accepted the Stewardship Code are expected to comply or explain in the same way as described above on the Governance Code. An institutional investor s explanation for any noncompliance should be included in its periodic report on how it fulfils its stewardship responsibilities (see Principle 6 under Main principles of the Stewardship Code in the appendix below). Future review and revision of the Codes The FSA is expected to review the Stewardship Code periodically, about once every three years. The Governance Code is expected to be reviewed periodically to ensure that it continues to achieve its objectives under rapidly changing economic and social circumstances. In practice, it is reasonable to expect that the Governance Code will also be reviewed on a threeyear cycle. 184 Number of institutional investors voluntarily accepting the Stewardship Code (as of 12 March 2015) The Governance Code states explicitly that offering a superficial explanation using boilerplate expressions would be inconsistent with the concept of comply or explain 7 See: www.fsa.go.jp/en/refer/councils/stewardship/20150312.html 3

Appendix Main principles of the Governance Code Below is a summary of the General Principles under the Governance Code, together with commentary on some of the more topical of the specific principles in each section of the Governance Code. Section 1: Securing the rights and equal treatment of shareholders The General Principle of this section states that listed companies should: take appropriate measures to fully secure shareholder rights (including voting rights) and develop an environment in which shareholders can exercise their rights appropriately and effectively; secure effective equal treatment of shareholders based on the class and number of shares they hold; and give adequate consideration to the issues and concerns of minority and foreign shareholders as regards effective exercise of their rights and effective equal treatment of shareholders (including, for example, making available English translations of documents as well as electronic voting functionality). This section also directly addresses some corporate governance practices in Japan that are frequently raised by foreign investors as areas of concern. For example: Principle 1.3 states that listed companies should explain their basic strategy with respect to capital policy given its potentially significant effect on shareholder returns, and Principle 1.6 requires listed companies to examine (and explain to shareholders) any capital policy that may harm shareholder interests (eg that would result in change of control or significant dilution); Principle 1.4 requires listed companies to disclose their policies with respect to any cross-shareholdings in other listed companies (including voting of any such cross-shareholdings) and to examine the mid- to long-term economic rationale and future outlook of major cross-shareholdings on an annual basis; and Principle 1.5 states that any anti-takeover measures must not have any objective associated with entrenchment of existing management and requires the boards 8 of listed companies to examine (and explain to shareholders), in light of their fiduciary duties, the necessity and rationale of any anti-takeover measures. Section 2: Appropriate co-operation with stakeholders other than shareholders The General Principle of this section states that: listed companies should fully recognise that their sustainable growth and the creation of mid- to long-term corporate value are brought about as a result of the provision of resources and contributions made by a range of stakeholders, including employees, customers, business partners, creditors and local communities, and thus they should endeavour to appropriately co-operate with these stakeholders; and the boards and management of listed companies should exercise their leadership in establishing a corporate culture where the rights and positions of stakeholders are respected and sound business ethics are ensured. Additionally, this section specifically addresses: sustainability issues, including social and environmental matters (in Principle 2.3); diversity, including active participation of women (in Principle 2.4), stating that listed companies should recognise that the existence of diverse perspectives and values reflecting a variety of experiences, skills and characteristics is a strength that supports their sustainable growth, and therefore promote diversity of personnel; and whistleblowing (in Principle 2.5), stating that listed companies should establish an appropriate framework for whistleblowing such that employees can report illegal or inappropriate behaviour, disclosures or any other serious concerns without fear of suffering from disadvantageous treatment. 8 And, if applicable, the statutory auditor(s) (kansayaku). See footnote 9 below. 4

Section 3: Ensuring appropriate information disclosure and transparency The General Principle of this section states that: listed companies should not only make appropriate information disclosure in compliance with relevant laws and regulations, but should also strive to actively provide information beyond that required by law (including both financial information, such as financial standing and operating results, and non-financial information, such as information on business strategies and business issues, risk and governance); and the boards of listed companies should recognise that disclosed information will serve as the basis for constructive dialogue with shareholders, and therefore ensure that such information, particularly non-financial information, is accurate, clear and useful. This section additionally provides that disclosures should add value for investors and should not be boilerplate and/or lacking in detail and that listed companies should take steps to provide English language disclosures, to the extent reasonable having regard to the number of foreign shareholders. Section 4: Responsibilities of the board The General Principle of this section states that the boards of listed companies should, in light of their fiduciary responsibility and accountability to shareholders, appropriately fulfil their roles and responsibilities to promote sustainable corporate growth and the increase of corporate value over the mid- to long-term and enhance earnings power and capital efficiency. This includes: setting the broad direction of corporate strategy; establishing an environment where appropriate risk-taking by the senior management is supported; and carrying out effective oversight of directors and the management from an independent and objective standpoint. Such roles and responsibilities should be equally and appropriately fulfilled regardless of the form of corporate organisation. 9 While it may not be unusual from a UK perspective for the roles and responsibilities of the board to be so clearly defined, this is relatively novel for Japan. It is notable, however, that the Governance Code does not include an equivalent to Principle A.2 of the UK Governance Code providing for a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the company s business. Principles 4.7, 4.8 and 4.9 set out specific provisions relating to independent directors: Principle 4.7 states that listed companies should make effective use of independent directors, taking into consideration a number of specified expectations for their roles and responsibilities these expectations include monitoring the appointment and dismissal of senior management, monitoring conflicts of interest between the company and management and/or controlling shareholders and representing the views of minority shareholders and other stakeholders from an independent standpoint. Principle 4.8 provides that listed companies should appoint at least two independent directors and consider optionally appointing at least one-third of directors as independent directors. 10 The independent directors should also endeavour to put in place a framework for communicating with management (eg by appointing one of their number as a lead independent director). Principle 4.9 requires the boards of listed companies to establish and disclose independence standards aimed at securing effective independence of independent directors, taking into consideration the independence criteria set by securities exchanges. Principle 4.14 specifically provides for ongoing board training, stating that listed companies should provide and arrange training opportunities suitable to each director 11 (along with financial support for associated expenses) and that the board should verify whether such opportunities and support are appropriately provided. Section 5: Dialogue with shareholders The General Principle of this section states that: listed companies should engage in constructive dialogue with shareholders, even outside the general shareholder meeting, to contribute to sustainable growth and the increase of corporate value over the mid- to long-term; and during such dialogue, senior management and directors, including outside directors, should listen to the views of shareholders and pay due attention to their interests and concerns, clearly explain business policies to shareholders in an understandable manner to gain their support, and work towards developing a balanced understanding of the positions of shareholders and other stakeholders and acting accordingly. This is the section of the Governance Code that most closely interacts with the Stewardship Code. It also provides that listed companies should put in place and disclose policies for constructive dialogue with shareholders, which should include, among other matters, appointing a member of management or a director responsible for overseeing and ensuring that such dialogue takes place and measures to control insider information when engaging in such dialogue. 9 Japanese companies may choose one of three main forms of organisational structure under the Japanese Companies Act: a company with statutory auditor(s) (kansayaku) a structure unique to Japan and used by most companies, a company with a committee system (nomination, audit and remuneration) or a company with a supervisory committee. 10 The Governance Code goes beyond recent amendments to the Japanese Companies Act, which require listed companies to appoint only one outside director. This represents a significant step forward for Japan on the issue of outside/independent director representation, although it is still somewhat short of Principle B.1.2 of the UK Governance Code, which provides that at least half the board of FTSE350 companies, excluding the chairman, should comprise non-executive directors determined by the board to be independent. 11 Principle 4.14 also applies to statutory auditor(s) (kansayaku) in the case of a company with statutory auditor(s). 5

Main principles of the Stewardship Code The Stewardship Code is based closely on its UK equivalent and most of its principles, summarised below, are similar to those in the UK Stewardship Code. A notable omission in the Japan version is an equivalent to Principle 5 of the UK Stewardship Code relating to collective action by institutional investors. Guidance to Principle 7 of the Japan Stewardship Code (see below) does, however, state that exchanging views with other investors and having a forum for the purpose may help institutional investors conduct better engagement with investee companies and make better judgements. Principle 1: Stewardship policy Institutional investors should have a clear policy on how they fulfil their stewardship responsibilities (ie a stewardship policy ), and publicly disclose it. The stewardship policy should cover how the institutional investor defines the responsibility and how it fulfils it in view of its role in the investment chain. Principle 2: Managing conflicts of interest Institutional investors should have a clear policy on how they manage conflicts of interest in fulfilling their stewardship responsibilities (eg when voting on matters affecting both the institutional investor or its group and a client/beneficiary), and publicly disclose it. Principle 3: Monitoring of investee companies Institutional investors should monitor investee companies so that they can appropriately fulfil their stewardship responsibilities with an orientation towards the sustainable growth of investee companies. A variety of factors, including non-financial ones, may be relevant to the monitoring process and institutional investors should use their own judgement in deciding which factors to focus on in light of their stewardship responsibilities to specific investee companies. Principle 5: Voting Institutional investors should have a clear policy on voting and the disclosure of voting activity. They should try to articulate the policy as much as possible and not produce a merely mechanical checklist: it should be designed to contribute to sustainable growth of the investee company. Principle 6: Reporting Institutional investors should report periodically on how they fulfil their stewardship responsibilities, including their voting responsibilities, to their clients and beneficiaries. They should also record their stewardship activities, including voting activities. Principle 7: Knowledge, skills and resources To contribute positively to the sustainable growth of investee companies, institutional investors should have in-depth knowledge of their investee companies and their business environment as well as the skills and resources needed to appropriately engage with the companies and make proper judgements in fulfilling their stewardship activities. Institutional investors should continually endeavour to improve the quality of their stewardship activities. As mentioned above, exchanging views with other investors may help institutional investors improve the quality of their engagement with investee companies and make better judgements. Institutional investors should also aim to improve their stewardship policies and voting policies based on periodic reviews of their previous engagements with investee companies. Principle 4: Engagement with investee companies Institutional investors should seek to arrive at an understanding in common with investee companies and work to solve problems through constructive engagement with investee companies. If an institutional investor identifies a possible loss in corporate value through its monitoring of and dialogue with an investee company, it should request further explanation from the company with a view to solving the problem. This material is provided by the international law firm Freshfields Bruckhaus Deringer LLP (a limited liability partnership organised under the law of England and Wales) (the UK LLP) and the offices and associated entities of the UK LLP practising under the Freshfields Bruckhaus Deringer name in a number of jurisdictions, and Freshfields Bruckhaus Deringer US LLP, together referred to in the material as Freshfields. For regulatory information please refer to www./support/legalnotice. The UK LLP has offices or associated entities in Austria, Bahrain, Belgium, China, England, France, Germany, Hong Kong, Italy, Japan, the Netherlands, Russia, Singapore, Spain, the United Arab Emirates and Vietnam. Freshfields Bruckhaus Deringer US LLP has offices in New York City and Washington DC. This material is for general information only and is not intended to provide legal advice. Freshfields Bruckhaus Deringer LLP, May 2015, 03371