As Japan, Inc. continues to restructure, enthusiasm for corporate governance reform is gaining ground.

Japan has amended its national corporate law twice since 2003, encouraging companies to add more shareholder-friendly elements, such as accounting and auditing practices. Some firms are also restructuring boards around a committee system, appointing outsiders and paring down the number of directors. Even a few hostile takeover attempts — long considered a business taboo in consensus-seeking Japan — have erupted, although none has yet succeeded.

Yet while Japan is taking steps toward more Western-style governance, Wharton faculty and graduates who work in Tokyo say shareholders will never rule supreme. Concern for a range of stakeholders — including customers, suppliers and, most importantly, employees — will always be a part of Japan’s corporate landscape.

Franklin Allen, co-director of Wharton’s Financial Institutions Center, stresses that Japanese business culture is different from most Western capitalist systems where shareholder return is the central goal. While Japanese firms strive to create value, he says, they view their corporations almost like non-profits. Returns are used to nurture and grow the organization, not only to reward investors.

While many Japanese companies have undergone painful restructuring in the post-bubble period, most firms still put the welfare of their employees on a par, or above, return on investment. “There’s a huge reluctance to fire people. It’s very deep-seated,” says Allen. “In Japan, they still don’t think of the corporation as being for the shareholders. They think it’s for the stakeholders, including the workers and the customers.”

According to John Thomas, former president of J.P. Morgan Trust Bank in Tokyo, Japan does not have much of a social safety net. As a result, corporations provide for the well-being of citizens. “Shareholder rights are less important than the survival and success of the corporation,” says Thomas, who now runs a consulting firm outside San Francisco. The basic notion of investing for profit is not part of the Japanese approach to business, he continues. “The public is suspicious of money making money. They accept the idea of making things, but the idea of investing and making money on investments is something that, generally speaking, is not embraced as a social value.”

He recalls attending a meeting with Japanese executives who laid out a global strategy to export steel. Their plan was to provide higher quality steel at lower prices than competitors, with no accounting for return on investment. To some extent, Thomas says, Japanese government support for industry and historically low interest rates allowed corporations to ignore investors. “The idea of earning a high return for shareholders has not been a long-standing concept in Japan.”

Ranked Second-to-last

Among industrialized nations, Japan still comes in second-to-last, ahead of only Greece, in corporate governance rankings compiled by GovernanceMetrics International (GMI), an independent research firm in New York. GMI analyzed 3,800 global companies using more than 400 corporate governance metrics for its study released in September 2006.

On a 10-point scale, the 409 Japanese firms studied scored 4.01, lower even than the 321 firms based in emerging markets that scored a combined 4.30.

Howard Sherman, chief operating officer of GMI, says Japanese firms have made important strides in unwinding cross-shareholdings that had been the basis of its long-standing Keiretsu system (under which interlinked banks and corporations covered up weaknesses in individual firms). The system is, in large part, to blame for Japan’s bubble economy of the 1980s that ultimately burst. However, he adds, “Japanese companies have not taken the next major step, which is toward a pro-shareholder governance regime.” In addition, Sherman says, the Japanese government has amended corporate law to make mergers and acquisitions easier, but many companies are resisting this with new takeover defenses.

The highly publicized attempt by Livedoor, an upstart Tokyo Internet company, to take control of Nippon Broadcasting System’s radio network in 2005 rocked corporate Japan and was hailed as a breakthrough for shareholders. (In corporate Japan, hostile takeovers have long been considered taboo because they would disrupt the cooperative system of cross-shareholdings.) Later, after the founder of Livedoor, Takafumi Horie, was arrested on charges of violating securities law, the company’s stock crashed. Horie is currently on trial. “It wound up leaving a bad impression in the minds of both Japanese businesspeople and government officials,” says Sherman. “It started out as a legitimate takeover defense, but it developed into a scandal that has poisoned the well.”

Thomas points to another takeover attempt which, even though it failed, is a sign that corporate Japan may be opening up.A hostile bid by Oji Paper, Japan’s biggest paper company, for smaller Hokuetsu Paper fell through when Nippon Paper, the second-largest paper company in Japan, came in as a white knight. Nomura Securites Co., one of Japan’s most influential investment firms, was an advisor to Oji. In the past, he says, Nomura has sided with efforts to block takeovers.

“If Nomura is willing to be on the unfriendly side now, to me that is a small sign, but evidence that the company feels it is socially acceptable, at least in certain circumstances, to challenge the system,” Thomas says. “I think it’s inevitable that there will be better recognition that shareholders have some rights.”

Letting Outsiders Come In

Sony is among the few Japanese companies to make major changes in its governance structure. The company reduced the size of its board, added outsiders and formed three managing committees overseeing nominations, auditing and compensation.

Yotaro Kobayashi, the non-executive chairman of Sony, says Japanese firms are gradually allowing outsiders to play a greater role on corporate boards. Traditionally, the president of a Japanese company handled short-term, day-to-day operations. Long-term strategic issues were the concern of the chairman, who most likely was a former president. “That combination worked quite well for a long time,” says Kobayashi, “but it was not systematic enough. So now more companies are adopting the corporate governance model where non-executive, outside board members are invited to be on the board — not necessarily to be the majority, but sufficient in number that they can have influence on the management decisions.”

Kobayashi, who is the former chairman of Fuji Xerox in Japan, estimates that only about 25% of Japanese firms have adopted a U.S. board structure. Furthermore, he notes, Canon and many other Japanese companies oppose the idea that outsiders can bring any value to the firm. “As long as things are going well, that’s okay, but when you are in a rough sea and things are changing, you cannot rely totally on the wisdom of directors who are at the height of their management careers. You still need other views,” says Kobayashi.

In the wake of the scandals at Enron and WorldCom, he adds, the Japanese are wary that catering to shareholders could eventually undermine the health of companies that have been nurtured in Japan for centuries. “People in Japan are very concerned about the short-term orientation of the day traders or the Internet traders who just don’t care about the long-term interests of the corporation,” he says.

To address those concerns, Japanese corporate law has been amended to allow firms to structure committee systems within their boards to create a mix of shareholder influence with a long-term perspective. The payoff could be a greater presence on the global financial scene, says Kobayashi. “The courts have tried to change toward a more systematic governance model that can be understood easily in a global framework. The key element will be what sort of outside governors these companies can mobilize to be on their boards.”

According to Sherman, Japanese companies that refuse to improve their corporate governance profile will suffer when they try to compete for international investment. “Most Japanese companies are governed as if they cater to a Japanese-only investment profile. In reality, there is a lot of cross-border money coming into Japan, and that’s where I think the pressure to change is going to come from.”

Japan’s continued recovery, and the overall health of global financial markets, may depend on the world’s second-largest economy improving its corporate governance profile, he contends. “There’s a lot riding on Japan’s ability to keep pulling itself out of a prolonged recession. From our perspective, one missing ingredient is continued progress in improving its corporate governance system.”

A Strong Voice for Savers

Sarah McLellan, a research analyst at Morgan Stanley, agrees that international investors are pushing Japanese corporate governance reform. Another growing force is pension funds.

The post-bubble crash and the “accounting big bang” of policy reforms in its aftermath have led to a large unwinding of corporate cross-holdings and relationships with principal banks that were often characterized by goals other than a firm’s profitability, she says. At the same time, razor-thin returns drove big pension funds and institutions to focus on passive investment in indexed portfolios where good corporate governance, across the board, enhances return.

Japan’s Pension Fund Association, the eighth largest pension fund in the world, with $110 billion under management, is leading the change and has become an outspoken voice for corporate governance reform. “The PFA suffered from several years of consecutive losses in the beginning of this century,” McLellan says. “I understand they brought in a number of different investment managers, but soon realized it was not the managers’ stock-picking but more likely the underlying companies. If the companies were not paying enough attention to shareholder value, then the PFA would. This led the PFA to take a more active stance on corporate governance.”

According to McLellan, although their approaches are different, the PFA may be in Japan what CalPERS (the California Public Employees’ Retirement System) was in the United States 10 years ago — a strong voice for everyday savers. The Nihon Keizai Shimbun, one of Japan’s leading financial newspapers, calculated that the PFA opposed 40% of 171 proposed takeover defenses at 819 firms during annual meetings this spring. Compared to last year, when the PFA flat out rejected 99% of all defensive measure proposals, this year there seemed to be much more dialogue suggesting greater preparedness by companies.

Japan’s changing demographics is an underlying force in PFA’s aggressive stance and demand for shareholder rights, McLellan adds. As Japan continues to age, savings that earned little or no interest for years may not support retired Baby Boomers. “In order to sustain the standard of living and achieve economic growth when the labor side of the equation is declining, there has to be greater emphasis on efficiency. Efficiency can be in technical innovations, such as robotics, but return on equity — profitability — will also become much more important.”

While Japan is focusing more on corporate governance reform, the tentative economic recovery itself may prove to be an obstacle to large-scale change. “The recovery is a double-edged sword for those who don’t want to recognize the interest of the shareholder,” says Thomas. “The improved environment lets them delay. But I think the direction is clear although the pace will be slow.”

Allen, the Wharton finance professor, notes that those looking to defend the Japanese way often point to Toyota. Despite its bulky board of nearly 60 insiders, Toyota is on track to overcome General Motors as the world’s largest car manufacturer. “Toyota is the dominant car company now,” says Allen. “They have a long tradition of doing things their own way and are not particularly shareholder-oriented, but it happens they are doing a lot better than GM and Ford.”