Is this the end of the Japanese corporate officer system?

Corporate officers are a feature of the various Japanese governance systems

Almost 20 years after Sony introduced the term ‘corporate officer’ there are indications that a number of Japanese companies are beginning to move away from the practice.
According to press reports, housing equipment company Lixil Group removed the rank entirely in July this year. Rohto Pharmaceutical also removed the corporate officer system in May and Koei Chemical took a similar step in June.
I asked Nicholas Benes, head of the Board Director Training Institute of Japan, about the changes and whether it presaged wider governance changes in Japan. “The biggest reason that some companies in Japan are now reducing the number of corporate officers,” he said, “is that they have too many of these executives and need to streamline decision-making and get rid of less productive positions. It’s part of the general trend towards performance-based management.” However, in order to understand the changes, Benes carefully explained where corporate officers sat within the various Japanese governance systems.
“The Corporate Officer term – shikko yakuin in Japanese – is not a legal term,” he noted. “If you asked most people in the street what they understood by it, many would answer that it meant someone was on the board, but this is not the case. It is just a senior-sounding title that was created about 15 years ago, to give to executives when they reduced the size of boards from 30-40 persons or more to much smaller numbers.

“Since not everyone who was ‘senior’ could sit at the board any more, Japanese corporations simply created a new title for them that had no legal basis. Yakuin means board member, but they are not members of the board, just senior managers employed under labour law contracts. This means they are difficult to fire and are less easily criticized by shareholders, unlike directors, who can be voted off the board or not re-nominated.”
This lack of legal backing for the term could conceivably create problems in the way Japanese companies can conduct their business. “One potential problem with corporate officers is that they usually have a kind of ‘apparent authority’, but no fiduciary duty. They may be able to bind the company by concluding contracts that cannot in practice be rescinded, but they cannot be sued by shareholders for doing so. This is different from U.S. ‘executive officers’, who can be sued by investors.”
But not all Japanese companies have this type of “title only” corporate officer, explained Benes. “There are three main corporate governance structures in Japan – the kansayaku style, the audit committee style, and the three-committees style. It is the first two structures that most frequently utilize this type of corporate officers.
“The 3-C style is the one that most closely resembles US governance practice, there’s about a 70% similarity. The board decides long-term strategy and policy and appoints executive officers that do have legal standing and potential liability as such, and these executive officers report to the board but are not necessarily board members. In practice, one defect of this structure is that in many cases, a large number of executive officers are also on the board, sometimes five or six, which calls into question how independent the board actually is. Also, there are only three pre-set committees – audit, nomination and compensation. No others are allowed.”“With kansayaku companies,” he continued, “there are no legally recognized committees of the board, although there may be advisory ones on an optional basis. Legally there is just a board that usually is composed of a significant majority of executive directors, and a separate ‘kansayaku board’ which operates similarly to an audit committee. The kansayaku who sit on the latter board – also known as ‘statutory auditors’- have no vote at meetings of the board of directors because it is thought that to allow that would compromise their independence. If they were to vote, they would be auditing the adequacy of their own decisions, is the logic of the system.”
These statutory auditors have powers that are not found in other governance systems, said Benes. “Although the statutory auditors cannot vote at board meetings, they have very significant powers. They don’t have to seek the permission of the main board, or even each other, to make internal investigations. They can order executives to cease actions that do not comply with the law, or seek a court order to force them to stop. Each statutory auditor can decide to do these things on his or her own cognizance.” But while this oversight system would seem to be a most effective one, it has built-in problems.
“One ‘glass half full’ aspect of the system is that one or more of the statutory auditors are often ‘former’ managers with a long history with the company so they retain a real ear to the ground. However, the full benefit of this is not always realized, because in practical reality they are often selected by the President, so their independence may be compromised by that. Another weak point of the kansayaku style of governance is that the board can delegate fewer matters to management, so board meetings tend to get bogged down in minutiae.”
Benes is most supportive of what he calls the 3-C governance structure, which is not widely adopted. “Unlike kansayaku companies and audit committee-style companies,” he said, “three-committee-style company boards are required to appoint legally-defined executive officers who bear a fiduciary duty – as do executive officers at US companies. But less than 2% of all listed companies use the 3-C governance structure.”
On the other hand, Benes finds it encouraging that even without being required to do so, some kansayaku companies are moving closer to the 3-C model of fiduciary-type executive officers.
“Some smart companies – Fast Retailing is one, Sato Holdings is another – have made the decision to employ their corporate officers on a ‘fiduciary style contract’ basis (as opposed to a ‘labor contract basis’) so that their duties can be more precisely defined, and they can more easily be fired or sued. Another benefit of doing this is that such contracting forces officers to reset their mindsets to a higher level professional standard. The companies ask mangers to resign from their existing labor contracts under labor law and sign fiduciary contracts. Such contracts make it possible to fire someone if their performance is not good enough. It can bring higher pay, but more risk, to the executive’s role, which can be a very healthy thing in today’s changing Japan.”

Asked whether he thought that the removal of the corporate officer class or the hiring of fiduciary-style executives would become the model of the future, Benes said: “I don’t have a sense of whether this model is becoming more popular but these examples [Fast Retailing and Sato Holdings] could lead to more companies adopting it, which might at one point put pressure on the Ministry of Justice to adopt a legally defined ‘executive officer” role that must be used by kansayaku and audit committee companies.” And it is not just the lack of legal grounding or full accountability that besets the corporate officer system, explained Benes. “Right now, the problem is that if a company needs to suddenly appoint a new CEO from outside the board, it can be a very messy and inefficient process. Take the example of Olympus. Everyone on that board was chosen by the powerful Chairman, Tsuyoshi Kikukawa, so they were all tainted by the same scandal that led to his downfall.“So the company needed to reach out as soon as possible to appoint new directors from outside the board. But under the current system, no one can be appointed CEO unless they already sit on the board. Thus, appointing a new CEO under such circumstances requires several months to pre-negotiate and nominate new members to the board, all the while coordinating with institutional investors precisely when they have lost trust in the company, and then to hold an EGM and elect them. No wonder investors lose confidence in such cases.”
The new Japanese corporate governance code had nothing to say about whether any particular type of corporate officer system was good or bad, or whether companies should seek ways to reduce the numbers of such officers, but it would seem that companies are reaching their own conclusions about how effective different versions of the corporate officer role are, and how to make each more effective. “While there has been only slow gradual change for a number of years,” commented Benes, “when Japan moves decisively, it can change relatively fast.”