1. 1 Legal and Regulatory Framework for Corporate Governance: A Japanese Perspective December 14, 2001 Hideki Kanda Professor of Law University of Tokyo

2. 2 Major Topics Basics –Where do laws and regulations matter? Four areas –(1) illegal activities and conflict of interest transactions –(2) investor protection –(3) shareholder activism –(4) recent reforms of company law in Japan

3. 3 Basics (1) What is corporate governance? –(1) a mechanism for preventing and controlling illegal activities (such as fraud, stealing and waste of assets) by managers, employees and others –(2) a mechanism for enhancing company performance

4. 4 Basics (2) What laws and regulations matter and how? –Basic laws and regulations are important, such as company law, insolvency law, securities regulation and criminal law. –Laws and regulations must be enforced. –Laws and regulations are not everything, and thus shape only part of the entire system of corporate governance.

5. 5 Four Topics (1) illegal activities and conflict of interest transactions (2) investor protection (capital market regulation) (3) shareholder activism (4) recent reforms of company law in Japan

6. 6 Topic 1: Illegal Activities and Conflict of Interest Transactions Japanese experience: two types of illegal activities –illegal payment to disrupting shareholders at shareholders’ meetings –insider trading Japanese response –wrote special rules with criminal sanction Lesson –we need an effective prosecution system and a reliable judicial system.

7. 7 Topic 1: Illegal Activities and Conflict of Interest Transactions - An Addition Role of company law –Role of the board –Role of shareholder derivative action Japanese experience –Shareholder derivative actions were effective in some cases of illegal activities.

8. 8 Topic 2: Investor Protection - the problem - Any system does not function well unless accompanied by proper regulation and proper enforcement. The costs of regulation and enforcement are not zero. How to design and maintain effective regulation and enforcement is the key.

9. 9 Topic 2: Investor Protection - the problem (continued) - Imagine a world where there is one simple rule: “do not do bad things.” In this world, the cost of enforcement is prohibitively high. To reduce the cost of enforcement, there must be more specific rules. To write such rules is costly, and the optimal level is difficult to determine. For proper enforcement, there must be other legal infrastructures, such as a well-functioning judicial system.

10. 10 Topic 2: Problems of the Capital Market System In general, the capital market system is better than the bank system – but if the costs of regulation and enforcement are zero! Investors, not intermediaries, take investment risks. Opportunities to defraud investors Relatively difficult to regulate, because there is no focal point? Misregulation leads to a disaster.

11. 11 Topic 2: Regulation of Capital Markets The need of three strong regulations –strong investor protection –strong watchdog or enforcer (“SEC”) –strong regulation of institutional investors Preparing and maintaining these three strong regulations are not costless.

12. 12 Regulation of Capital Markets (1) Strong investor protection –transparency and fairness –“mandatory disclosure” and “anti-fraud rules” Dealing with the collective action problems of bondholders –Trust Indenture Act of 1939 (U.S.) Broker-Dealer Regulation –conduct regulation and segregation rules –safety-net and capital regulation

13. 13 Regulation of Capital Markets (2) Strong enforcement –For disclosure, proper accounting rules and proper auditing requirement must be provided. A reliable CPA system must exist. –Both for disclosure and anti-fraud, a strong enforcer (SEC) is necessary. –The role of private litigation may be important. A well-functioning judicial system must be provided. The class action system must be recognized.

14. 14 Regulation of Capital Markets (3) Strong regulation of institutional investors –The capital market system does not mean the lack of financial intermediaries. –Intermediaries, such as mutual funds and pension funds, are popular. –Strong fiduciary regulation on these intermediaries is necessary. –Strong enforcement is necessary here, too.

15. 15 borrowerinvestors The Capital Market System: Basics

16. 16 borrowerinstitutionsinvestors The Capital Market System: Reality

17. 17 Regulation of Capital Markets (4): The Japanese Framework a complex system of disclosure, accounting and auditing a unique two-board system: the board of directors and the board of auditors

18. 18 Japan: Two-Board System board of directorsboard of auditors

19. 19 US and other countries: One board with committees board of directors audit committeecompensation committee nominating committee

20. 20 Japan: Practice (tradition) Life-time employment system Bank-based finance Mutual stockholdings

21. 21 Japan: Practice (tradition) implications Life-time employment system –Almost all directors and managers were former employees. Bank-based finance –The main bank’s role was important. Mutual stockholdings –Shareholders were silent and hostile takeovers were difficult.

22. 22 Japan: Practice (today): No.1 Life-time employment system –Changing.. Outside directors are becoming popular, though the change is gradual. Bank-based finance –The main bank’s role is disappearing. Mutual stockholdings –Melting..

23. 23

24. 24 Japan: Practice (today): No.2 A board of statutory auditors action resulted in the resignation of president of a listed company. There were hostile takeover attempts (not successful).

25. 25 Topic 3: Shareholder Activism Who are active shareholders? –United States public pension funds unions individuals? private funds (e.g. mutual funds) are inactive shareholders –Japan life insurance companies? other institutional shareholders? individuals?

26. 26 U.S.: What do Active Shareholders do? Formal actions –proxy fight –proposal –derivative action –other Informal actions –negotiation with management

27. 27 U.S.: Shareholder Proposals by Activists increase the number of independent directors on board eliminate poison pills or other defensive measures against hostile takeovers reduce executive compensation ask for confidential voting –For a survey of empirical studies, see Romano, Less is More: Making Institutional Investor Activism a Valuable Mechanism of Corporate Governance (working paper, 2001)

28. 28 Japan: Legal Framework proxy fight – difficult because of mail voting right to proposal right to ask questions shareholder derivative action action for invalidation of a resolution of the shareholders meeting

29. 29 Japan: Practice The life insurance industry complains low level of dividends at portfolio companies every year. proxy fights: none derivative actions: popular proposal right: popular, but mostly on social matters right to ask questions at the shareholders meeting: popular, but mostly on social matters other actions: action for invalidation of a resolution of the shareholders meeting is somewhat popular.

30. 30 Stated Purpose of Shareholder Activism U.S. institutions: enhancing shareholder value (=enhancing firm performance) –Unions may have other goals. –Individuals may have other goals. Japan: not clear, often social matters

31. 31 Topic 4: Company Law Reform in Japan Many reforms –Amendments in June 2001: Deregulation of share repurchases –Amendments in November 2001: Deregulation of stock options and recognition of electronic means in company law –Amendments in December 2001: Liability limitation of directors and auditors and strengthening of the auditor system –Expected amendments in 2002: Change in the board of directors and related matters

32. 32 Japan: Company Law Reform (1) A bill for amending Company Law (Commercial Code) was passed in the Diet on November 21, 2001. It deregulated the stock option system. Stock options can be issued to anyone. This is expected to be used as incentive mechanisms in the future.

33. 33 Japan: Company Law Reform (2) A bill for amending Company Law (Commercial Code) was passed in the Diet on December 5, 2001. It introduced the limitation on the liability of directors and statutory auditors, and strengthened the statutory auditor system.

34. 34 Japan: Company Law Reform (2) New statutory auditor rule –At least half of the members of the board of auditors must be independent auditors (for all “large” companies). –The definition of independence is stricter.

35. 35 Japan: Company Law Reform (2) Liability limitation will apply only when the director/auditor is not grossly negligent and will not apply in certain category of actions (such as illegal dividends).

36. 36 Japan: Company Law Reform (2) New rule on the liability of directors and statutory auditors (where applicable): Maximum amount of liability to the company: –Representative directors: 6 year amount of the annual compensation –Directors and statutory auditors: 4 year amount of the annual compensation –Outside directors: 2 year amount of the annual compensation

37. 37 Japan: Company Law Reform (3) An exposure draft by the Ministry of Justice was published in April 2001 for public comments. It includes drastic changes (for all “large” companies) : –requiring at least one independent director on board –choice between the statutory auditor system and the system of a single board with the audit committee, the compensation committee and the nominating committee

38. 38 Tentative Conclusion Laws and regulations are important in corporate governance. –preventing illegal activities –protecting minority shareholders from dominating shareholder's misbehavior –protection of investors in capital markets Applying “rule of law” rather than “rule of person” in corporate governance will be an exciting challenge in Asia for the coming decades.