MW-14 -- BUZZWORDS VS. SHAREHOLDER ACTIVISM

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J@pan Inc Magazine Presents:
M O N E Y W A T C H
Weekly Financial Commentary from Tokyo
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Issue No. 14
Wednesday, February 5, 2003
Tokyo

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Viewpoint: BUZZWORDS VS. SHAREHOLDER ACTIVISM

The Bottom Line:

o While the policy debate about what the government should do to
revitalize Japan rages on, the Nikkei 225 continues to sink to
lows not seen in 20 years, and bond yields continue to push
toward 0 percent as the economy stumbles toward another
cyclical recession.

o At the micro-level, an equally important debate about
corporate governance rages on amid a historic destruction of
investor capital. There is continued resistance by large
Japanese companies to more stringent corporate governance,
even though there is increasingly clear evidence that good
corporate governance pays and that investors are actually
willing to pay a premium for good corporate governance.

o The most encouraging trend in this regard is not that Japanese
management has begun to use the right buzzwords or that they
are superficially adopting Western management ideas and
techniques. Rather, it is growing signs of investor activism.
This "credible exit threat" shows the most promise of ending
the laissez faire era of corporate governance in Japan and of
forcing significant change in terms of a more efficient
utilization of capital.

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BUZZWORDS VS. SHAREHOLDER ACTIVISM
A Corporate Governance Debate at the Micro-Level
The top-down debate rages on about just what the government and the
Bank of Japan can do to revitalize Japan's economy, eradicate
deflation and liquidate the growing mountain of nonperforming loans.
But the Nikkei 225 continues to shrink to new 20-year lows, and
Japanese government bond (JGB) yields continue to renew new lows, to a
mere 0.75 percent recently. The latest buzzwords in policy circles are
"inflation targeting" and "deflation countermeasures." To some, these
are one and the same, but to others, the terms mean more aggressive
fiscal stimulus or yet another bailout of the banks and heavily
indebted companies. Meanwhile, the only tangible result of the Koizumi
administration's "reforms" are plunging stock prices and bond yields.

At the micro-level, another debate over buzzwords rages on amidst
historic destruction of capital -- the corporate governance and
corporate social responsibility debate. While corporate management
despairs of any substantiative change for the better in government
policy, one also has to wonder where their shareholders and boards of
directors were as the major banks destroyed trillions of yen of market
capitalization, and the major debt-ridden retailers and construction
firms drove the price of their stock from the thousands of yen to
essentially "penny stock" levels. According to the Japan Corporate
Governance Forum, "a good company maximizes the profits of its
shareholders by efficiently creating value, and in the process
contributes to the creation of a more prosperous society by enriching
the lives of its employees and improving the welfare of its
stakeholders."

But during the entire Heisei Malaise, there has been no governance
body to force management of these capital destroyers to clean up the
problem or lose their jobs. At the same time, the corporate governance
system has apparently been unable to prevent a litany of corporate
scandals involving anything from bribery to investor fraud to the sale
of tainted milk.

The usual answer for this almost total lack of corporate governance is
that Japanese companies did not have to consider shareholder value
and, for that matter, any outside monitoring. Tight, interlocking
shareholdings with other companies and banks, and boards of directors
that were all company employees created another web of "insider"
corporate stakeholders.

Banks long led corporate governance in Japan, providing personnel,
funds and other kinds of support to companies in which they are major
shareholders in return for management information. In fact, corporate
governance based on personnel, financial and shareholding ties between
banks and companies was once given as a foundation of stable
management in Japan. But what has been regarded as a pillar of
corporate governance in Japan has collapsed during the Heisei Malaise.
Banks are liquidating cross-shareholding ties and are reluctant to
send officials to troubled companies, as they no longer want to get
involved in management. Moreover, banks can no longer afford to extend
generous loans.

Yet amid the obvious unwinding of these cross-holding relationships,
management of poorly managed companies continues to wonder why the
company's stock prices are so depressed, why analysts never come to
visit them anymore, or why both domestic and foreign individual
investors have dropped their stock from their portfolios. In other
words, they do not realize that they now have to compete for capital.

Commercial Code Amendments
Amendments to the Commercial Code taking effect in April will allow
large companies capitalized at 500 million yen or more, or companies
that have debts of at least 20 billion yen, to opt for US-style
corporate governance. Companies adopting the system will have to
appoint executive corporate officers to handle day-to-day
decision-making for each business operation and keep them independent
of the board of directors. Firms will also be required to set up three
committees charged with nominating candidates for board membership,
setting executive salaries and supervising company operations, while
abolishing existing auditor positions, which are generally filled by
insiders. Each committee will consist of at least three board members,
and more than half of the committee members must be recruited from
outside the company. Major companies will have to decide whether to
switch to the US system by their next shareholder meetings.

Lectures and seminars for business executives on corporate social
responsibility and corporate governance are rapidly gaining in
popularity as a discussion theme. The booming popularity of such
lectures and seminars is a reflection of the fact that Japanese
companies are trying to take a new look at their own operations
through the prism of corporate social responsibility. But the mounting
interest in this also appears to stem from fears of being blind-sided
by new regulations and laws. (The situation reminds MoneyWatch of
1991, when Nomura was embroiled in a scandal involving illicit trades
with organized crime, and Japan moved to make "insider trading"
illegal. The concept of insider trading was so unfamiliar that the
Tokyo Stock Exchange was showing the movie "Wall Street" to brokers as
a training film. Japanese management are still uncertain about the
concept of fair disclosure, as outlined in the SEC's regulations).

Meanwhile, governments in Europe are putting pressure on individual
companies to tighten their managerial discipline. They are forcing
firms to release reports on their compliance with laws and
regulations, and to publish statements on their corporate governance
practices. The US has passed the tough Sarbanes-Oxley law, which
ostensibly makes no distinctions between US and foreign firms issuing
securities in the US.

Continued Management Resistance
But nearly 60 percent of large companies surveyed by Nikkei have
decided not to adopt a US-style corporate governance system. So far,
only Orix, Daiwa Securities, Sony, Konica-Minolta, Hitachi and Toshiba
have indicated interest in adopting the US system. This means that the
majority of Japanese companies prefer to have insiders appoint board
members and serve as auditors, which of course impairs the
transparency of their operations. The reluctance stems from the fact
that top management does not want to cede power to a committee. At
many companies, the current president chooses his successor. Japanese
firms are also skeptical about the US system because it did not
prevent their US counterparts from committing serious financial
misconduct as exemplified by Enron and Worldcom.

Fujio Mitarai of Canon, who was chosen as one of the world's top 25
managers by BusinessWeek, is the major spokesman for this resistance.
Mitarai's management style is neither old Japan nor a carbon copy of
US management techniques. He believes that the science and systems of
management (such as accounting systems, technology development,
financial and product strategies) should be international and
standardized. But in the areas of culture and tradition, he thinks
that management must think locally.

He believes, for example, that appointing outside directors is
meaningless. Japanese management in the first case does not understand
the difference between directors and executive directors, as both are
essentially insiders in the Japanese system. He is also against stock
option plans and is a proponent of lifetime employment.

The provisions of the Sarbanes-Oxley law are especially contentious.
In particular, Japanese companies have taken strong exception to the
requirement for a board-audit committee consisting of no less than
three members that cannot be corporate officers or employees of
affiliates. Moreover, these members should be financially literate,
and at least one member of this committee has to have accounting and
financial management expertise. Japanese companies are resisting
because the provisions conflict with the Japanese system of statutory
auditors. It is also being resisted by the Japan Institute of
Certified Public Accountants. Should the US SEC insist that foreign
issuers in the US market adopt these measures, Japanese companies
currently listed on US markets, beginning with Canon, would seriously
consider de-listing from the US.

Stock Market Darlings
As Abraham Lincoln said, "You can fool all of the people some of the
time, and some of the people all of the time, but not all of the
people all of the time". By the same token, being a darling of the
stock market at any particular time is not a reliable indicator of
superior management. Despite the widespread malaise in Japan, the
stock market is rewarding company presidents who have bold management
strategies and who have practiced active disclosure since they took
office. But a Nikkei ranking of 300 major corporations shows how
fickle investors can be, especially when their trust in a company's
management is violated.

In its list of CEOs that destroyed market capitalization are two
former darlings of Japan's TMT (tech, media, telecoms) bubble: NTT
Docomo and Softbank. Softbank was once lionized as a visionary of
Japan's Internet revolution but in retrospect is shown to have
destroyed market capitalization. NTT Docomo's i-mode revolutionized
mobile phones, but some very ill considered overseas investments have
subsequently resulted in massive losses for the company. The phenomenon
is not unique to Japan. In the US, both WorldCom and Enron
at one time were Wall Street darlings and their management lionized by
investors. According to the Nikkei survey, the CEOs that have grown
their company's market capitalization since taking office include:

Carlos Ghosn, Nissan
Chihiro Kanagawa, Shinetsu Chemical
Yashihiro Yasui, Brother Industries
Fujio Cho, Toyota
Fujio Mitarai, Canon
Tatsuro Funai, Funai Electric
Takuya Goto, Kao
Hiroshi Suzuki, Hoya
Kunio Takeda, Takeda Chemical
Shigenobu Nagamori, NIDEC
Masamitsu Sakarai, Ricoh

Performance Enhancer?
The current consensus among academics and investors is that good
corporate governance enhances a company's performance, works to
maximize shareholder value and helps distill a degree of trust among
foreign investors. By the same token, large outside investors are
generally believed to reduce agency costs of corporate governance by
monitoring and disciplining managers. But throughout the 1990s, there
were a plethora of government and regulatory body inquiries on
corporate governance throughout the world, including reports from the
World Bank and the OECD, and a host of business and corporate seminars
where corporate governance standards and approaches were debated. The
seminars continue.

However, a fairly clear trend is that ownership structure matters,
particularly as regards concentrated ownership by the state or
specific groups. A Norway study (Oyvind Bohren, Bernt Arne Odegaard)
of companies listed on the Oslo Stock Exchange concludes that
ownership concentration destroys value. In addition, the value of a
firm decreases in proportion to board-of-director size with the use of
non-voting shares and when firms finance with more debt and pay higher
dividends.

A study of Chinese companies (Xiaonian Xu and Yan Wang, 1997) found a
significant positive correlation between ownership and profitability,
where labor productivity tends to decline as the proportion of state
ownership increases. A study by Andreas Moerke
(http://skylla.wz-berlin.de/pdf/1997/iv97-43.pdf)appears to bear this
out in the case of Japan. The study found that belonging to a
keiretsu firm in Japan is no longer a guarantee of success. Indeed,
old keiretsu firms: a) tend to pay higher wages than independent
firms, b) pay lower dividends per share, c) have larger boards of
directors, d) have more directors dispatched from financial
institutions, and e) appoint more "amakudari" (literally "descent from
heaven"; when retiring government workers are offered jobs at a
private-sector firm in hopes of winning influence with that government
body). In other words, keiretsu firms are more isolated from market
forces and competition for capital. Sung Wook (June 2001) also found
that independent firms in South Korea outperformed chaebol firms, so
the phenomenon is not peculiar to Japan.

Importance of Nonfinancial Indicators
A study by Ernst & Young ("Measures that Matter?") concludes that for
70 percent of investors, at least 30 percent of a decision to buy is
based on nonfinancial performance indicators, i.e., qualitative
considerations not directly linked to the company's financials. Smart
companies (and investors) are searching for ways to incorporate
intangibles such as quality of management, customer retention, R&D and
innovation into their evaluation criteria, making corporate governance
increasingly important. A July 2002 survey by McKinsey & Company of
professional investors from 31 countries shows that: a) corporate
governance is now an established investment criterion, and b)
investors are willing to pay a premium for a well-governed company.

There will always be a minority of companies (as there are in Japan)
that focus on cash flow/profit, their core businesses and capital
efficiency, while at the same time recognizing that good corporate
governance, business ethics and corporate responsibility have a
favorable impact on their long-term performance. But what about those
companies that don't get it?

Mere Buzzwords
Mitarai gives the following reasons for a company's existence, which
MoneyWatch believes are as good as any:

1. Provide stable employment for employees (employees sure of
their employment future make better consumers).
2. Provide adequate shareholder returns.
3. Make a contribution to society (i.e., pay taxes, be a good
corporate sponsor).
4. Earn enough equity capital to invest in the future.

But what is the common factor needed to fulfill all of these goals?
Profits! Japanese firms often muddle the methodology with the
objective, which is profits. In other words, the business exists
because it produces profits. If profits cannot be made in a business,
then the company must change its methodology. If management cannot
change the methodology to produce profits, then management needs to be
changed. In other words, it all begins and ends with profits.

But as Mitarai has observed regarding the importation of US management
methods, Japan's problem is not with the system per se but with
management itself. Many managers blame poor performance on the system
but in reality are really just transferring blame away from
themselves. As Sung Wook has pointed out about South Korea, the
factors in Japan's weak corporate governance structure include: a) no
credible exit threat, b) lack of bank monitoring, c) the "moral
hazard" of government support for the losers instead of the winners,
d) weak minority shareholder rights and d) negligent boards of
directors.

Simply importing a US infrastructure and overlaying it on a Japanese
organization will not produce good corporate governance in Japan. As
Mitarai has pointed out, the objective of the system of outside
directors in the US is often subverted by the fact that outside
directors are scouted and introduced by the CEO, (75-90 percent are
provided with stock compensation, according to Directors and Boards
magazine) and are incapable of critiquing management's business
decisions. A 2002 survey by McKinsey & Co. of US corporate directors
has backed up Mitarai's claim, revealing that much of the reform that
has taken place in boardrooms over the last decade in the US has been
more cosmetic than substantive.

Thus, perceptive investors will look beyond superficial
infrastructures put in place just because "everyone expects it."
Unfortunately, many Japanese companies have introduced various
management reforms during the extended economic slowdown, with many of
these being "American-style management." While many companies have
initially attempted to introduce these reforms, they appear to have
stopped at superficial reforms without changing the substance of the
company itself.

MoneyWatch remembers when return on equity (ROE) first became a
buzzword in Japan and management teams were expected by analysts and
investors to give their ROE targets. Most senior management members
could give you a target, but few could really clearly explain just how
they planned to achieve that target.

Hiroaki Niihara, research fellow at RIETI (Research Institute of
Economy, Trade and Industry), recently conducted a study of the skills
of the best managers at superior Japanese companies. His research
revealed the following characteristics of superior Japanese companies,
none of which has anything to do with pre-determined corporate
governance infrastructures:

1. Top management has an unambiguous understanding of the scope
of the business in which the company is engaged, and it avoids
lines of businesses it does not understand.

2. Top management is logical in that it considers actions long
and hard itself. Many managers in Japan have studied and
become well versed in management theories from Japan and
abroad. The divide is whether one simply crams in the
knowledge or thinks through its implications for their
company. Managers of superior companies never unconditionally
accept conventional wisdom. These managers can actually
explain the logic for every one of their decisions, without
exception.

3. Many members of top management of superior companies have
spent some time in peripheral departments, subsidiaries or
affiliates during their careers, allowing them to be more
entrepreneurial and to make bolder decisions.

4. An indomitable spirit among these top managers allows them to
turn crisis into opportunity.

5. They directly examine business risk while aiming for growth
suited to the company's structure and capabilities. Superior
Japanese companies also feature independence unfettered by
capital markets because of superior cash flow management.

6. Another element of superior Japanese companies is that
managers impart to the company a sustainable culture of
discipline. In other words, discipline by the capital markets
is a necessary, but not sufficient condition to produce a
sustainable superior company.

7. Finally, a feature of superior companies is the simple belief
that the key to corporate governance is a sense of mission and
an ethical code among employees, not a system.

Growing Investor Activism
Of the previously mentioned factors behind Japan's almost non-existent
corporate governance, MoneyWatch believes that the emergence of a
"credible exit threat" is potentially the most powerful future force
driving corporate governance and change at the micro-level in Japan.
There are signs that the laissez faire era of corporate governance in
Japan is finally coming to an end:

o Money management firms are now being required by public
pension fund sponsors to vote their shares according to a
pre-determined set of voting guidelines and to report back on
how they voted. For example, the Public Pension Fund
Association, which takes over pensions for workers who have
pulled out from their employers' pension funds as well as
assets from dissolved pension funds, is pressing its asset
management firms to actively exercise their voting rights. It
voted against 15 out of 150 management proposals at last
year's shareholder meetings and, over the next couple of
years, aims to build a structure that enables it to screen out
troubled firms with two yardsticks: earnings and corporate
governance standards. It is also considering using CalPERS'
(California Public Employees' Retirement System) shareholder
activism tactics as a model for its activities.

o CalPERS itself has teamed up with SPARX Asset Management in
Japan and Relational Investors LLC in California to set up a
pilot ($200 million) Japan Corporate Governance Fund to make
significant investments in a small number of Japanese
companies and "collaborate with management to increase the
value of the companies for the benefit of shareowners,
employees and other stakeholders." The Pension Fund
Association has expressed an interest in teaming up with
CalPERS. Such an alliance could have a dramatic impact on how
Japanese companies view corporate governance.

o M&A Consulting, headed by ex-bureaucrat Yoshiaki Murakami, has
been making hostile bids for Japanese companies since 1999. He
sees shareholder value becoming the new Japanese standard,
given new accounting standards and enhanced visibility,
unwinding of cross-holdings, growing foreign ownership and an
aging society combined with massive under-funding in the
pension system. He pushes companies to focus on cash
flow/profit, focus on core businesses, capital efficiency,
board monitoring, executive compensation aligned with the
interests of shareholders, higher dividend payouts and share
buybacks.

o High net worth individual shareholders are also becoming more
activist. Chozo Nakagawa, who had invested in 3,000 shares of
Nippon Shimpan, has initiated a 46 billion yen class action
suit against it directors. Nakagawa quit his job in July of
last year to prepare for the lawsuit. Moreover, he studied
commercial law on his own and plans to act without hiring a
lawyer. Kanehide Yoneyama is a major shareholder of Konaka,
Sekiwa Real Estate and Yuraku Real Estate.Yoneyama started
investing in stocks seriously in 1998, using funds earned
running his own business. As a major shareholder of Kiriu,
Yoneyama pressured management to raise production
efficiency and ultimately encouraged the eventual sale of
Kiriu to Unison Capital. Yoneyama is now making waves at
Konaka, where he is the fifth-largest shareholder, with 1.02
million shares.

o More organizations are closely watching corporate governance
at individual companies, rating them for their corporate
governance standards and corporate responsibility regarding
environmental and other social issues. Goldman Sachs has
prepared a ranking of Japanese corporations in terms of
corporate governance based on items such as who owns shares,
return on equity and employee stock-option plans. The
brokerage looked for relations between its rankings and stock
prices, and found a direct correlation between higher rankings
and higher stock prices. Morningstar, in conjunction with the
nonprofit Public Resource Center, is developing a stock index
of 100 Japanese companies noted both for profitability and
social responsibility. Akiyama of IntegreX specializes in
assessing the level of Japanese companies' social
responsibility through questionnaire surveys of the nation's
3,530 listed companies. The survey is meant to assess
companies' awareness of their social responsibility and
what systems they have on hand to assure responsible
operations. Several trust banks that manage pension funds are
negotiating with IntegreX to use the survey results in
building their investment portfolios. The Japan Corporate
Governance Index Research Group has created the JCG Index
(www.jcgr.org) from a survey of 1,504 listed Japanese
companies, of which only 159 companies responded. The index
measures how closely the firm adheres to the "Revised
Corporate Governance Principles" of the Japan Corporate
Governance Forum (www.jcgf.org/en/). Of a possible 100, the
average of the companies that responded was 36.3, with most
firms scoring lowest in the function of the board of
directors.

o Employee corporate governance. Employees themselves are
learning that they need to follow their company's performance.
Matsushita Electric maintains an internal electronic message
board as part of an initiative to beef up disclosure to
employees. This board now lets employees view quarterly
earnings figures, posted with comparisons with competitors.
Major entertainment producer Horipro has seen employees become
more active. It is not uncommon for employees to press
management with hard questions like: "Why is our stock price
below Yoshimoto Kogyo's?" Nissan's Carlos Ghosn has made a
particular effort to keep employees informed and involved in
the company's fortunes, installing TVs where the production
line stops in the factories so employees can watch important
top management presentations.

-- Darrel Whitten

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