The debate over corporate governance: a special section for professional investors focused on Japan. (Investor Insight).

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 amid 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 has to wonder where their shareholders and boards of directors were when 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.

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 plus 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 continue 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 [yen]500 million or more, or companies that have debts of at least [yen]20 billion, to opt for US-style corporate governance. Companies adopting the system will have to appoint executive corporate officers to handle day-to-day decisionmaking 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.

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 Business Week, 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. Should the US SEC insist that foreign issuers in the US market adopt these measures, Japanese companies currently listed on US markets would seriously consider de-listing from the US.

As Mitarai observes 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. Thus, perceptive investors will look beyond superficial infrastructures put in place just because "everyone expects it."