Japan's corporate landscape has been undergoing a significant transformation, driven by a concerted effort to enhance corporate value, attract global investment, and foster sustainable growth. At the heart of this evolution are substantial revisions to its Corporate Governance Code, closely intertwined with a major restructuring of the Tokyo Stock Exchange (TSE) market segments that took effect in April 2022. For U.S. legal professionals and business leaders engaging with Japanese companies—whether as investors, partners, or through subsidiaries—a nuanced understanding of these evolving governance standards is no longer just advantageous, but essential.

The Trajectory of Corporate Governance Reform in Japan

Japan's journey with modern corporate governance principles gained significant momentum in the early 2000s, accelerating particularly after the introduction of its first Stewardship Code in 2014 and the initial Corporate Governance Code in 2015. These codes, operating on a "comply or explain" basis, were designed to encourage companies to adopt best practices voluntarily, fostering a shift from a traditionally insular corporate culture towards greater transparency, accountability, and focus on shareholder returns.

The Corporate Governance Code has since seen several revisions, with the 2021 update being particularly impactful. This revision was strategically timed to align with the TSE's market restructuring, imposing more demanding standards, especially on companies listed on the newly established "Prime Market." The overarching goals have been consistent: to improve the international competitiveness of Japanese corporations and to build a corporate sector that is responsive to the expectations of a diverse range of stakeholders, including global institutional investors.

Core Pillars of Japan's Corporate Governance Code (2021 Revision)

The 2021 revision of the Corporate Governance Code reinforced and expanded upon several key areas. While the Code applies to all listed companies on a "comply or explain" basis, certain principles carry heightened expectations or specific quantitative targets for companies on the Prime Market.

1. Enhancing Board of Directors' Effectiveness

A central theme of the reforms is the strengthening of board functions, independence, and diversity.

• Board Independence: The Code emphasizes the importance of independent outside directors in overseeing management and representing the interests of minority shareholders. For companies on the Prime Market, the requirement is notably stricter: they are expected to appoint at least one-third of their board members as independent outside directors (Principle 4-8 of the CG Code). For other markets, the general expectation is at least two independent directors. For companies with a controlling shareholder or those with complex group structures, a majority of independent directors may be expected even on the Prime Market. The definition of "independence" is also a critical aspect, focusing on individuals who have no conflicts of interest with the company.
• Nomination and Remuneration Committees: To enhance objectivity and transparency in executive appointments and compensation, the Code encourages the establishment of nomination and remuneration committees with a majority of independent directors, particularly for Prime Market companies.
• Board Diversity: Recognizing that diverse perspectives contribute to better decision-making and innovation, the Code calls for companies to promote diversity among board members, including gender, international experience, and professional background. Companies are encouraged to disclose their policies and voluntary, measurable targets for ensuring diversity, particularly in the appointment of women, non-Japanese nationals, and mid-career hires to managerial positions.
• Skill Matrix: Companies, especially those on the Prime Market, are prompted to disclose a "skill matrix" identifying the key skills and expertise possessed by each board member and how the board as a whole is equipped to address the company's strategic challenges.
• Board Effectiveness Reviews: Regular, objective evaluations of board effectiveness are encouraged, with summaries of the results to be disclosed.

2. Securing Shareholder Rights and Promoting Engagement

The Code seeks to ensure that shareholders, particularly minority shareholders, are treated fairly and have their rights protected.

• Equal Treatment of Shareholders: A foundational principle is the equal treatment of all shareholders according to their shareholding.
• Capital Policy: Companies are expected to provide clear explanations for their capital policies, including their stance on return on equity (ROE) targets, dividend policies, and share buybacks, especially when their capital efficiency is low.
• Constructive Dialogue: Companies, and notably those on the Prime Market, are urged to engage in proactive and constructive dialogue with their shareholders. This includes creating an environment conducive to such dialogue, such as scheduling general shareholder meetings to avoid peak days and providing convocation notices and materials well in advance, including in English where there is a significant proportion of overseas investors.
• Voting Rights: Ensuring the effective exercise of voting rights is crucial. This includes promoting electronic voting platforms and providing sufficient time for institutional investors to consider proposals.

3. The Role of Institutional Investors: The Stewardship Code Nexus

Japan's Stewardship Code, first introduced in 2014 and subsequently revised, complements the Corporate Governance Code. It outlines principles for institutional investors to fulfill their stewardship responsibilities, encouraging them to engage with investee companies to promote sustainable growth and enhance corporate value over the medium to long term. The Corporate Governance Code, in turn, encourages companies to respond positively to such engagement. This interplay is vital for fostering a healthy investment chain.

4. Addressing Environmental, Social, and Governance (ESG) Factors and Sustainability

The 2021 revision significantly bolstered the emphasis on sustainability and ESG issues.

• Sustainability as a Core Management Issue: Companies are expected to develop a basic policy on their sustainability initiatives and disclose them. This includes considering investments in human capital and intellectual property.
• Climate-Related Disclosures (TCFD): A landmark addition, particularly for Prime Market companies, is the expectation to enhance the quality and quantity of their climate-related disclosures. This is explicitly linked to the recommendations of the Task Force on Climate-related Financial Disclosures (TCFD) or equivalent frameworks (Supplementary Principle 3-1③). Companies are expected to assess the impact of climate change risks and earning opportunities on their business strategies and performance.
• Human Capital and Intellectual Property: The Code encourages companies to view investments in human capital (e.g., employee training, promoting diversity, ensuring fair labor practices) and intellectual property as crucial for long-term value creation.
• Supply Chain Management: There is an increased focus on addressing human rights and environmental issues within supply chains.

5. Ensuring Transparency and Disclosure

Enhanced disclosure is a cornerstone of the reforms, aimed at providing investors with the information necessary for informed decision-making and effective engagement.

• Cross-Shareholdings (Policy-Held Shares): The Code continues to push for a reduction in strategically held shares by other listed companies. Companies are required to disclose their policy regarding such holdings, explain the rationale for holding them, and conduct an annual review of the economic rationale and associated risks and benefits of major holdings. The aim is to improve capital efficiency and reduce potential conflicts of interest.
• Related Party Transactions: Robust procedures for managing and disclosing transactions with related parties (e.g., directors, major shareholders) are emphasized to prevent conflicts of interest and protect minority shareholder interests.
• Information Disclosure in English: For companies with a significant proportion of overseas shareholders, particularly those on the Prime Market, disclosure of key information in English is strongly encouraged and, in some aspects, becoming a de facto requirement to facilitate engagement with global investors.

Specific Focus Areas from the 2021 CG Code Revision

The 2021 revision introduced or strengthened several specific areas, many of which have particular relevance for companies listed on the Prime Market:

• Enhanced Board Independence: As mentioned, the one-third independent director ratio for Prime Market companies is a key quantitative change. The focus is not just on numbers but on the substantive contribution of these directors to effective oversight.
• Board Skill Matrix Disclosure: This requirement aims to make the board's collective expertise more transparent and to encourage a strategic approach to director nominations.
• Promoting Diversity: The call for voluntary targets and disclosure regarding diversity in management and at the board level signals a stronger push beyond mere tokenism.
• TCFD-Aligned Climate Disclosures: This is a significant step, aligning Japan with global trends in ESG reporting and requiring Prime Market companies to take a more strategic approach to climate risks and opportunities.
• Sustainability Initiatives: The broader emphasis on sustainability encourages companies to integrate these considerations into their core business strategies.
• Group Governance: For companies that are part of complex corporate groups, the Code calls for effective governance systems that ensure the interests of minority shareholders in listed subsidiaries are not unfairly prejudiced.

The "Comply or Explain" Principle: A Unique Feature

A defining characteristic of Japan's Corporate Governance Code is its "comply or explain" approach. This means that companies are not strictly mandated to adhere to every principle in the Code. Instead, if a company chooses not to comply with a particular principle, it must provide a clear explanation for its non-compliance in its corporate governance report.

This approach offers flexibility, allowing companies to tailor their governance structures to their specific circumstances, industry, and stage of development. However, it also places the onus on companies to provide convincing justifications for any deviations, and on investors to scrutinize these explanations. For U.S. entities accustomed to more rules-based governance regimes, understanding the nuances and practical application of "comply or explain" is crucial when assessing Japanese companies. The quality of explanations can vary, and a lack of compliance coupled with a weak explanation can be a red flag for investors.

Practical Implications for U.S. Businesses

The evolving corporate governance landscape in Japan has several direct and indirect implications for U.S. businesses:

• For U.S. Investors in Japanese Companies:
  • Enhanced Due Diligence: The Code provides a clearer framework for assessing the governance quality of investee companies. Investors should look beyond mere statements of compliance and examine the substance of a company's governance practices and explanations for non-compliance.
  • Engagement Focus: The increased emphasis on ESG, board independence, and shareholder dialogue creates more avenues for U.S. institutional investors to engage with Japanese management on critical issues.
  • Market Segmentation Signals: A Prime Market listing, for instance, should theoretically indicate a higher commitment to governance, which can be a useful, though not definitive, screening factor.
• For U.S. Companies with Japanese Subsidiaries:
  • Aligning Standards: While the Code directly applies to listed Japanese companies, its principles are increasingly influencing governance expectations for unlisted companies as well, including subsidiaries of foreign parents. U.S. parent companies may find it beneficial to ensure their Japanese subsidiaries are aware of and, where appropriate, align with relevant aspects of the Code to meet local stakeholder expectations.
  • Talent Acquisition and Retention: Strong governance and a commitment to sustainability, including human capital development, can enhance a subsidiary's reputation and attractiveness as an employer in the Japanese market.
• For U.S. Companies in Joint Ventures or Partnerships with Japanese Firms:
  • Partner Vetting: The governance practices of a potential Japanese partner can be a critical factor in the success of a joint venture. The Code provides a useful checklist for evaluating a partner's commitment to transparency, accountability, and ethical conduct.
  • Negotiating Governance Terms: When establishing joint ventures, U.S. companies should be mindful of Japanese governance norms and ensure that the agreed-upon governance structure for the JV aligns with best practices and protects their interests.
• General Due Diligence Considerations:
  • Understanding a Japanese company's approach to "comply or explain" is key.
  • Reviewing corporate governance reports, shareholder meeting minutes (where available), and sustainability reports can provide valuable insights.
  • Assessing the actual influence and effectiveness of independent directors and committees, rather than just their presence, is important.

Challenges and Future Outlook

Despite significant progress, challenges remain in fully embedding best-practice corporate governance across Japan. These include:

• Substance over Form: Ensuring that compliance with the Code is substantive rather than a mere box-ticking exercise.
• Cultural Shifts: Overcoming deeply ingrained corporate cultural norms that may sometimes run counter to principles of transparency and external oversight.
• Effectiveness of Engagement: While dialogue is encouraged, the actual impact of investor engagement on company behavior can vary.
• Continuing Evolution: Corporate governance is not static. Japan will likely continue to refine its Code and expectations in response to domestic developments and global trends.

The ongoing reforms signal a clear direction of travel towards a more investor-friendly and globally aligned corporate governance environment in Japan. The emphasis on board independence, diversity, sustainability, and constructive shareholder dialogue is creating a more dynamic and accountable corporate sector.

Conclusion

The evolution of corporate governance in Japan, spearheaded by revisions to the Corporate Governance Code and the TSE market restructuring, marks a pivotal moment for the nation's business environment. These changes are not merely cosmetic; they reflect a fundamental shift towards prioritizing long-term corporate value, sustainable growth, and greater alignment with global investor expectations. For U.S. companies and legal professionals, staying abreast of these developments is critical. A deeper appreciation of the principles underpinning these reforms, the practical application of the "comply or explain" approach, and the specific expectations for different market segments will enable U.S. entities to navigate the Japanese market more effectively, mitigate risks, and capitalize on the opportunities it continues to offer.