Month: July 2015

Japan does not have the best track record when it comes to exercising good corporate governance. In fact, it has long been viewed by investors as a “global pariah” for its poor treatment of corporate shareholders, according to George T Hogan, a former sell-side equity analyst in Tokyo and contributor for Investopedia.

But the Japanese Prime Minister Shinzō Abe and his cabinet are looking to improve their country’s less than desirable image and undo some of the negative sentiment expressed by overseas investors, chiefly by introducing a new corporate governance code.

The government is hoping the new system of rules will improve investor confidence, as well as help to make its equities market more attractive to foreign capital. The only problem is that for the new code to be successful it must go up against a cultural cornerstone of the Japanese economic system; one that has dominated the country since the middle of the 19th century, known as keiretsu.

It appears that, at the very least, poor corporate governance forces overseas investors… to exercise an extra degree of caution

While this structure of corporate governance can be traced as far back as the 1600s, it has gradually changed over many decades in order to suit the needs of Japan’s ever-evolving economy. Nowadays, the modern iteration of keiretsu sees corporations or corporate groups all centred on a bank, with each company possessing very close cross-shareholdings. What this means is that while the individual holdings of a company in one of the keiretsu group companies might be quite small, the aggregate of the entire group’s cross-shareholdings can be quite significant. This creates a number of issues that are positive for some stakeholders and problematic for others.

“If you’re an employee and what you are looking for is a stable environment where you are unlikely to be laid off, especially in tough economic times or when the company you work for is hurting financially, then it can be viewed as a relatively good thing”, says Hogan. “But if you are a shareholder, and particularly if you are a minority shareholder, an investor, not one of these cross-shareholding shareholders, then you can really have your rights trampled on.

“It can feel like the companies are not paying enough attention towards generating an adequate return on the investment you have made by buying their shares”, he says. “You seem to be put behind all other stakeholders in the chain.”

And while former sell-side analysts admits that US businesses have flaws of their own, they tend to pay a lot more lip service to shareholders than their Japanese counterparts. Not only that, but should investors in the US feel dissatisfied, then they have a number of options at their disposal. These include the right to appoint board members and officers or participate in a hostile takeover in order to ensure the company is acting in their best interests and maximising profits.

That is not to say that such options are not available to shareholders in Japanese companies, but its long-lasting corporate governance rules can make it difficult to express dissatisfaction with management in a meaningful way because minority shareholders tend to take a back seat.

“Minority shareholders or shareholders outside of the [keiretsu] group can be viewed as more of a nuisance, rather than a constructive contribution to how the company can be more effectively managed or made more profitable”, says Hogan.

Insulated world
The keiretsu structure and how it insulates companies from outside forces is apparent in numerous case studies, but the one that Hogan outlines in his article for Investopedia best highlights this unique characteristic in action.

Back in 2005, Rakuten – Japan’s answer to Amazon – tried to takeover one of Japan’s largest TV broadcasters, Tokyo Broadcasting System Inc. (TBS). At the time the network appeared unwilling to consider a bid under any condition or at any price. Its management was even prepared to dilute the online retailers’ 20 percent stake in the company to almost nothing in a last ditch attempt to stop the takeover from happening.

From the get go, Hiroshi Inoue, then president of TBS, expressed distaste at even entertaining the idea that the online retailer would become its affiliate. “It’s like you have a house of your own and, suddenly out of nowhere, someone comes up and tells you he wants to marry your daughter because he has purchased 20 percent of your land”, Inoue told journalists at a news conference.

The interesting point about TBS is it is one of six major nationwide television networks, which all have a lot of cross-shareholdings.

“Tokyo’s key TV stations cover seven prefectures in the Kanto region – home to the most wealthy segment of the nation’s population”, Minoru Sugaya, a professor of media communications at Keio University in Tokyo told The Japan Times. “Five private broadcasters control the lucrative market and they don’t want newcomers.”

And so, when Rakuten attempted to enter this market it was easy for TBS to rally all of their shareholders (which include these private broadcasters), and even though Rakuten was willing to pay a massive premium, the group companies stepped in and voted it down.

Scaring away investors
Examples like this do not exist in isolation and, from a shareholder perspective, especially one from say the US, where they have become accustomed to a different corporate governance structure, it has the potential to dissuade otherwise interested investors.

“I remember quite vividly receiving a comment from one of my clients – I had a very negative view of Rakuten while I was covering them – but one of my clients really liked them and he went through all the reasons why he liked them”, says Hogan. “He explained how they have great growth; the CEO and founder of the company is great, and he thought compared to other Japanese companies they were very aggressive in trying out new things. Despite all this, he ended the conversation saying that, ‘the only thing I don’t like about the company is it’s in Japan.’”

It appears that, at the very least, poor corporate governance forces overseas investors, who may be a little less experienced in how the Japanese market works, to exercise an extra degree of caution.

At least this “global pariah” clearly acknowledges the damage that is being done by its poor treatment of corporate shareholders, with its decision to introduce a new set of rules being a promising sign. Though this is not the first time that investors have heard of a plan to overhaul corporate governance only to be left wanting.

Toothless proposal
There is a level of pessimism for this new proposal. It derives from the fact that the plan is completely voluntary. The new rules may attempt to address rights of shareholders, cross-shareholdings, anti-takeover measures, whistleblowing, and board diversity, but without the ability to prosecute companies that do not adhere to the new code, it is unlikely they will comply.

But there is reason for investors to crack the faintest of smiles, as unlike previous attempts, this time round the government, the Tokyo Stock Exchange (TSE), and Nikkei (the leading financial media company), are all behind the proposal.

“That kind of behind the scene pressure could be very influential in the Japanese market, and I do think that the Abe administration is pushing for these changes quite hard”, says Hogan. “The TSE is using some of the elements in the new corporate governance code, almost as conditions for listing or for being on their new JPEX 400, which is a new benchmark.”

Instead of making the new rules a legal requirement these three key players are trying to gain some momentum behind the reforms. Nikkei in particular has been a big cheerleader for the new corporate governance code.

“There are a number of articles of an anecdotal nature almost every other day about a company coming along and either raising dividends, increasing pay-out ratios or more companies that are adopting outside directors, these types of things”, says Hogan. “It may not be very quantitative in nature, but Nikkei is throwing out a lot of anecdotes that show the benefits of complying with the new rules.”

By moving the market by influence, rather than trying to make every company move all at the same time in order to meet a new set of rules and regulations, this is approach aims to gently ease corporate Japan away from the entrenched ideals of the old keiretsu structure of corporate governance.

The aim of the new rules is to make the Japanese market more palatable to foreign capital, something that the country is in desperate need of considering the tough economic times that it is enduring. However, it is always easier to introduce rule changes when profitability is better; when it is easier to raise dividends, when pay out ratios are higher, and discussion about return on equity targets are more optimistic. Perhaps this momentum driven approach can find success. Either way, with such a poor corporate governance track record, investors will certainly welcome any progress in how shareholders are treated, no matter how small.

Pictures of a particularly jovial bunch of workers were splashed across the internet earlier this year when in April the CEO and founder of credit card processing firm Gravity Payments took a quite spectacular stance. Responding to an academic paper that said any salary under $75,000 could threaten workers’ emotional wellbeing, the company’s CEO Dan Price set about making $70,000 the minimum annual pay for his 120 staff.

Justified on the basis that better pay promises to generate profits in the long term, the hike has put Gravity in and among the ranks of America’s most admired companies. Taking over four years to implement, Price reduced his almost seven-figure salary to $70,000 and took a chunk out of Gravity’s earnings, though not without a great deal of fanfare.

Introduced in a time when the chasm between employee and executive pay is something of a hot topic politically, Price’s methods – while extreme – prove that there is real and growing pressure to take seriously the issues of rising executive pay and income inequality.

Sceptics have suggested meanwhile that Price’s sympathies, while commendable, will do little to powder the company’s financial complexion, with radio host Rush Limbaugh going so far as to proclaim: “It’s going to fail.” The fact remains that this is a privately-held company of only a few dozen employees, and one that shares little in common with the oft-criticised corporate giants, whose executive hand-outs number in the millions and executive-to-worker pay ratios in the hundreds.

Both sides of the debate feed into a far broader point about the balance of pay in the workplace, and the issue of whether executive remuneration for those at the world’s leading firms is at all justified stands idly in the firing line.

Rising executive pay
Figures provided by the Economic Policy Institute show that inflation-adjusted US executive pay in the period through 1978 to 2013 increased 937 percent, more than double what the stock market expanded in the same period. More important is the degree by which it eclipsed the 10.2 percent rise for typical workers. Whereas in 1965 the CEO-to-worker ratio stood at 20-to-1, by 2013 the ratio had widened to almost 296, even with much of the population still reeling from a financial crisis.

A cursory glance at some of the worst affected industries – fast food for example – has the ratio higher than 1000-to-1, and such numbers, according to a Demos report, threaten to bring “troublesome implications for the economy and for the companies”, if they’re allowed to continue on upwards. “Rising executive pay has played a big part in pushing up income inequality in the past 20 years”, says Deborah Hargreaves, Director of the High Pay Centre. “The average pay package for a leading FTSE 100 CEO last year touched £5m – that’s a five-fold increase since the late 1990s, while average incomes have barely risen over that period. That has driven a huge wedge between remuneration for those at the top and everyone else.”

Having risen largely without challenge for decades, it’s only in recent years that offending pay packets have been subjected to scrutiny, in boardrooms, in the media and in the wider public domain (see Fig. 1). In this time, millions of Americans have fallen on hardship and boards under far greater pressure to deliver shareholder value, and the issue of dysfunctional executive pay has made its way to the fore.

Research shows that rising levels of executive pay have perpetuated a poisonous societal gap between the richest one percent and the remaining 99, and for as long as pay fails to reflect performance, the issue threatens to breed resentment on an as-yet-unseen scale. “Pay levels have increased for highly skilled and highly talented individuals in many occupations – including athletes, surgeons, actors, professors, hedge fund executives, and software engineers – while the least skilled individuals in America keep falling further behind”, says Donald Hambrick, Evan Pugh Professor and the Smeal Chaired Professor of Management, Smeal College of Business, at The Pennsylvania State University. However, Hambrick adds that “rising executive pay plays a part — but only a minor part in America’s growing income inequality”, and the issue is not the amount paid out, but whether these sums are warranted.

Often justified on the basis that no less than stratospheric sums of money will drive candidates into the arms of competitors, a growing disconnect between achievement and reward is an issue more deserving of attention. “Current levels of executive pay are certainly off-putting, even offensive, for many Americans. But there’s no objectively defensible way to say that executive pay, or the CEO-to-worker ratio, is ‘too high’. How would we make such a determination?

“It’s important to recognise, for instance, that the CEOs of companies owned by private equity firms are paid just as highly as are the CEOs of publicly-traded corporations – after controlling for company size, industry, performance. Namely, owners who are vigilant, powerful, and intent on securing the best possible executive talent for their companies pay very handsomely to executives.”

Few would contest the point that any CEO capable of rescuing a major corporation from collapse is deserving of a multi-million dollar pay packet, though too often these same extraordinary sums are being paid out to those responsible for less-than-extraordinary work.

A pattern of rejection
For example, Barrick Gold took to the headlines in April when the company disclosed that 75 percent of shareholders had voted against its pay policies in a recent ‘say on pay’ vote. Chief among the grievances was an almost $13m pay package for Executive Chairman John Thornton, which in no way reflected the firm’s ever-so-slight improvement, both in terms of financial performance and share price.

Likewise, oil and gas major BG Group lopped millions off the top of its executive pay package late last year before the incoming Helge Lund took to the helm. Shareholders claimed that an initial share reward of £10m ($15.8m) for the first year marked an attempt to sidestep BG’s usual remuneration policy, and that the sum was far and above his $2.1m package at former employer Statoil.

Still, the discontent aired recently is far tamer than in the so-called shareholder spring of 2012, though remains an important trigger point for listed companies, particularly in instances where similar such grievances have been expressed previously. This growing pressure has brought greater rewards for the executives in question, according to some.

“Over the past 30 years”, says Hambrick, “increased pressures from activist investors, boards, and the press – especially in the form of more CEO dismissals – has made the CEO job riskier, thus contributing to increases in CEO pay.” Others claim, however, that a sharper focus on performance-linked pay has succeeded in putting a lid on wayward salary increases, and engagement with the issue has played a vital part in building more of a back-and-forth between boards and shareholders, and in raising transparency.

Having grown used to year-upon-year of double digit pay hikes for executives, analysis published by PwC in April showed that this trend could be grinding to a halt. Data for early 2015 showed that executive pay levels fell in real terms, and early signs indicate that 45 percent of FTSE 100 executives went without a salary increase in the period up to March 25.

“Companies are improving disclosure of bonus payments and targets in response to investor demands, writes Tom Gosling, Head of PwC’s reward practice, in a recent blog post. “Over the last few years investor pressure and regulation have led to a significant raising of the bar in executive pay. On the whole the right balance has been struck. Companies can still pay enough to attract talent, but the highest levels of pay are getting tougher to earn, with an improved link between pay and performance.”

Changing the rules
Whereas reports that suggest executive pay is spiralling fast out of control are widespread, the truth is rather that a changed policy stance, together with a growing engagement with shareholders, means that companies are exercising a far greater degree of restraint. Disclosure requirements are in fact far stricter today than they have been previously, and boards are more seriously considering recommendations put forward by shareholders.

As with a 2013 proposal to make disclosing the CEO-to-worker pay ratio a requirement, one newly proposed SEC rule to link executive pay to performance, if passed, would signal another important step on the road to more closely aligning company rewards and achievements. “These proposed rules would better inform shareholders and give them a new metric for assessing a company’s executive compensation relative to its financial performance”, says SEC Chair Mary Jo White of the rule. “The proposal would require enhanced disclosure that can be compared across companies.”

While it’s clear that a real and growing pressure to clamp down on wayward executive pay exists, it wasn’t until the Dodd-Frank Act was first signed into law that the US government took issue with the idea of pay detached from performance – at least outwardly enough to push for reform. Believing that on some level the issue was responsible for the 2008 crisis, policymakers in the US have made known their commitment to keep a lid on the discrepancy, and the shape of executive pay has changed – albeit ever-so-slightly – as a result.

“There has been some pressure from investors over huge pay-outs, for example at BG group, but generally, shareholders tend to be very complacent about big pay awards. Shareholdings are very dispersed and international and shares are held for short periods, meaning that investors don’t engage enough on pay”, says Hargreaves. “We need to tackle big pay gaps by broadening the membership of remuneration committees that set pay – currently they are mostly made up of executives, former executives and bankers, all of whom have benefited from a culture of high pay.”

Findings on the subject show that double digit pay hikes in the present climate are rare, and boards with a finger on the pulse are introducing measures that mean they can claw back bonuses, should any candidate fail to reach stated performance targets or fulfil their minimum contracted stay. Claims that executive pay is out of control are inflated, to the point that discussion on the topic is mostly ill informed and misdirected, though this isn’t to say that it does not warrant attention.

While the issue is driving a wedge between the top and everyone below, increased disclosure requirements and oversight mean that executive pay is no longer hidden from view, and proposals must stand up to shareholder scrutiny before they’re passed.

It’s imperative, therefore, that firms keep to these rules and, in doing so, enter executive pay into a period of stability. Only then will the issue of income inequality fade from the list of issues raised by workers and shareholders, and breed trust in much the same way Gravity did this year.