Corporate governance in Japan has undergone a remarkable transformation over the past two decades. Moving away from traditional models often characterized by insular boards, extensive cross-shareholdings, and limited shareholder engagement, Japan has embraced a series of reforms aimed at enhancing corporate value, improving transparency, and aligning with global best practices. This evolution is driven by a combination of government initiatives, market pressure from domestic and international investors, and a growing recognition within corporate Japan itself of the need for more effective oversight and strategic direction.

For U.S. businesses and investors engaging with the Japanese market, understanding the principles, structures, and ongoing evolution of Japanese corporate governance is essential for effective operations, investment decisions, and stakeholder engagement.

The Twin Pillars of Reform: Governance and Stewardship Codes

The bedrock of Japan's modern corporate governance framework consists of two key codes, both operating on a non-legally binding, principles-based approach:

1. Japan's Corporate Governance Code (CGC)

First introduced by the Tokyo Stock Exchange (TSE) in 2015 and subsequently revised (notably in 2018 and 2021), the CGC applies to all companies listed on the TSE.

• "Comply or Explain" Approach: The Code employs the "Comply or Explain" principle. Companies are expected to adhere to the principles outlined in the Code. If they cannot comply with a specific principle, they must explain the reasons for non-compliance in their annual corporate governance report. This approach encourages substantive engagement with governance principles rather than mandating a rigid, one-size-fits-all structure.
• Key Principles: The CGC covers a wide range of governance topics, with key principles emphasizing:
  • Securing Shareholder Rights and Equality: Ensuring fair treatment of all shareholders, including minority and foreign shareholders, and providing adequate information for exercising rights.
  • Appropriate Cooperation with Stakeholders: Recognizing that sustainable corporate value creation depends on cooperation with various stakeholders beyond shareholders (employees, customers, suppliers, local communities) and encouraging attention to ESG (Environmental, Social, Governance) factors.
  • Ensuring Appropriate Information Disclosure and Transparency: Mandating timely and accurate disclosure of both financial and non-financial information, including governance structures and policies.
  • Responsibilities of the Board: Defining the board's core functions (setting strategic direction, overseeing management, ensuring effective risk management) and emphasizing the need for objective, independent oversight. This includes promoting independent perspectives through external directors.
  • Dialogue with Shareholders: Encouraging constructive dialogue between companies and their shareholders (including institutional investors) to foster mutual understanding and contribute to sustainable growth.
• Focus Areas in Revisions: Revisions have progressively strengthened expectations, particularly regarding:
  • Board Independence: Increasing the number and role of independent external directors (独立社外取締役 - dokuritsu shagai torishimariyaku). The goal is typically for at least one-third of the board to be independent for Prime Market listed companies.
  • Board Diversity: Encouraging diversity in board composition, not just in terms of gender but also skills, international experience, and other attributes relevant to the company's strategy (Supplementary Principle 2.4.1 encourages disclosure of diversity policies and targets).
  • Sustainability/ESG: Explicitly incorporating the importance of addressing sustainability issues, including climate change (encouraging TCFD-aligned disclosures) and human capital management, into the board's responsibilities.
  • Group Governance: Addressing governance issues within corporate groups and relationships between parent companies and listed subsidiaries.

2. Japan's Stewardship Code

Introduced in 2014 and revised subsequently, the Stewardship Code targets institutional investors (asset managers, pension funds, insurers, etc.). It aims to promote sustainable growth of investee companies through constructive engagement and dialogue.

• Principles for Investors: The Code outlines principles for institutional investors regarding how they should fulfill their stewardship responsibilities, including:
  • Developing and disclosing clear policies on stewardship activities.
  • Understanding investee companies and their business environment.
  • Monitoring investee companies effectively.
  • Engaging with companies constructively based on sustainability considerations.
  • Developing clear policies on voting and disclosure of voting activities.
  • Reporting periodically on their stewardship activities.
• Impact: The Stewardship Code encourages investors to move beyond passive shareholding towards becoming active owners who engage with management on issues like strategy, capital allocation, risk management, and governance, including board composition and ESG performance. This investor engagement acts as a significant external driver for companies to improve their governance practices in line with the CGC.

Key Features and Trends in Japanese Governance

Beyond the two codes, several features and trends characterize the current governance landscape:

1. Board Structures:

Japanese companies can choose from several board structures under the Companies Act (Kaisha Hō):

• Company with Board of Statutory Auditors (監査役会設置会社 - Kansayaku-kai Setchi Gaisha): The traditional model, featuring a board of directors responsible for management decisions and a separate board of statutory auditors (kansayaku) responsible for auditing directors' execution of duties and accounting. Statutory auditors have strong independence but are not board members. This structure remains common, though less so among larger, internationally-oriented companies.
• Company with Audit and Supervisory Committee (監査等委員会設置会社 - Kansa-tō Iinkai Setchi Gaisha): Introduced in 2015, this structure features a board of directors where a majority of the members of a dedicated Audit and Supervisory Committee must be external directors. This committee has audit responsibilities, strengthening the board's oversight function. This model has gained significant popularity.
• Company with Nominating Committee, etc. (指名委員会等設置会社 - Shimei Iinkai-tō Setchi Gaisha): Closer to a US-style board model, this structure mandates three committees within the board: Nominating, Audit, and Compensation. Each committee must have a majority of external directors. The board focuses primarily on oversight, delegating significant operational authority to executive officers (shikkō yaku). While considered a strong governance model, its adoption rate is lower than the other two types.

The trend is generally towards structures that enhance board oversight, particularly through the increased involvement of independent external directors in key functions like auditing, nomination, and compensation.

2. Board Independence and Expertise:

There is a clear regulatory and market push for greater board independence.

• Role of External Directors: Independent external directors are seen as crucial for providing objective oversight, challenging management, and bringing diverse perspectives and expertise. The CGC sets targets for their number, and investors scrutinize their qualifications and true independence.
• Skills Matrix: Companies are increasingly encouraged (and sometimes disclose) a "skills matrix" for their board, identifying the key competencies needed (e.g., finance, technology, international business, ESG) and mapping current directors' skills against these needs to ensure the board has the appropriate collective expertise.

3. Board Diversity:

As extensively discussed in relation to specific legislation and the CGC, enhancing board diversity is a major focus.

• Gender Diversity: This remains the most prominent aspect, with government targets (e.g., 30% female executives by 2030 for Prime Market companies) and mandatory disclosures pushing companies to increase female representation. Progress is being made, particularly in appointing female external directors, but achieving significant representation among internal executive directors remains a challenge.
• Other Forms of Diversity: While gender is the primary focus currently, the CGC and broader governance discussions also encourage diversity in terms of skills, professional background, international experience, and age to enrich board deliberations.

4. Cross-Shareholdings (政策保有株式 - Seisaku Hoyū Kabushiki)

The practice of companies holding shares in their business partners or financial institutions for strategic relationship purposes (cross-shareholdings) has been a distinctive feature of Japanese corporate structure, but one often criticized for potentially entrenching management and hindering efficient capital allocation.

• Gradual Unwinding: The CGC requires companies to disclose their policies regarding cross-shareholdings and to examine the rationale and economic rationality of major holdings annually. While the unwinding process has been gradual, market pressure and governance concerns are leading more companies to reduce these holdings over time.

5. Shareholder Engagement and Activism:

Japan is experiencing a noticeable increase in shareholder engagement and activism.

• Institutional Investor Dialogue: Driven by the Stewardship Code, Japanese institutional investors (like pension funds GPIF and asset managers) are becoming more vocal in their engagement with companies on governance, strategy, and ESG issues.
• Foreign Activist Investors: Foreign activist funds have also become more prominent in Japan, targeting companies perceived as undervalued or having governance weaknesses, often pushing for changes like share buybacks, divestitures, or board reforms.
• Shareholder Proposals: There has been an uptick in shareholder proposals, including those related to climate change, board diversity, and other ESG topics, signaling greater shareholder willingness to challenge management directly.

6. Sustainability and ESG Integration:

ESG considerations are rapidly moving into the mainstream of corporate governance in Japan.

• CGC Emphasis: The CGC explicitly calls on boards to address sustainability issues as part of their core responsibilities.
• Climate Disclosure (TCFD): Companies listed on the TSE Prime Market are now expected to provide climate-related disclosures based on or equivalent to the Task Force on Climate-related Financial Disclosures (TCFD) recommendations.
• Human Capital Disclosure: Enhanced disclosure requirements regarding human capital management (diversity metrics, training investments, employee well-being initiatives) reflect the growing view that human capital is a key driver of long-term value.
• Board Oversight: Boards are increasingly expected to demonstrate how they are overseeing sustainability risks and opportunities and integrating them into corporate strategy.

Global Standards vs. Local Realities: The Balancing Act

Japan's governance reforms clearly show the influence of global standards and investor expectations. The principles outlined in the CGC and Stewardship Code broadly align with international norms like the OECD Principles of Corporate Governance. However, the implementation and overall governance landscape still retain some distinct characteristics and face ongoing challenges in fully converging with certain global practices.

• "Comply or Explain" Flexibility: While promoting engagement, the "comply or explain" approach means that the actual level of adherence to Code principles can vary. Some critics argue it can lead to boilerplate explanations rather than substantive compliance in some cases.
• Board Structure Variations: The continued prevalence of the statutory auditor system alongside committee-based structures means there isn't a single dominant board model, unlike in some other major markets.
• Pace of Change: While reforms are progressing, the pace of change in areas like unwinding cross-shareholdings or achieving high levels of gender diversity among internal executives can seem slow compared to the speed of change driven by harder regulations (like quotas) elsewhere.
• Cultural Context: Traditional corporate culture, emphasizing consensus, long-term relationships, and internal promotion, can sometimes create inertia against rapid governance changes demanded by external stakeholders.

Implications for U.S. Businesses and Investors

The evolving corporate governance landscape in Japan presents both opportunities and challenges:

• For Investors: Increased transparency (disclosures on diversity, sustainability, cross-shareholdings) provides better information for investment decisions and engagement. The Stewardship Code encourages a more receptive environment for dialogue with investee companies. However, understanding the nuances of different board structures and the practical realities behind "comply or explain" disclosures is crucial. Engaging effectively requires cultural sensitivity and a long-term perspective.
• For Companies Operating in Japan: Adhering to good governance practices aligned with the CGC is increasingly expected, even for non-listed subsidiaries of foreign parents, as it signals commitment to the Japanese market and responsible business conduct. Understanding disclosure requirements related to human capital and sustainability is vital for integrated reporting and stakeholder relations. When establishing subsidiaries, choosing an appropriate board structure and ensuring effective oversight mechanisms are key considerations. Partnering with Japanese companies requires due diligence on their governance practices.

Conclusion: A Journey, Not a Destination

Corporate governance in Japan is not a finished product but an ongoing process of adaptation and reform. Spurred by the need to enhance competitiveness, attract global investment, and meet evolving societal expectations, Japan has made significant strides in adopting principles of transparency, accountability, independence, and sustainability oversight. The Corporate Governance Code and Stewardship Code provide the central framework, guiding companies and investors towards practices that support long-term corporate value creation.

While uniquely Japanese characteristics remain and the pace of change varies, the overall trajectory is clearly towards greater alignment with global governance standards. For U.S. businesses and investors, navigating this landscape requires a nuanced understanding of both the formal rules and the underlying cultural context, recognizing that effective governance is increasingly seen as a prerequisite for sustainable success in the Japanese market.