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Remedy for a Healthy Industry Reorganization – On Ownership of Company Stock

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Remedy for a Healthy Industry Reorganization

The regeneration of private companies has been criticized as being rather sluggish in Japan for quite some time. As a nation, Japan’s corporate start-up and closure rate are both trailing around 5%, a figure that is among the lowest in developed countries.

Besides issues pertaining to small companies and venture spirit, the lack of dynamism (change brought on by the “survival of the fittest”) in large corporations could also be considered as an underlying cause in this situation. The Ministry of Economy, Trade and Industry (METI) has long identified this problem, and has since, especially after the collapse of the bubble economy, compiled numerous reports on the subject. Among them, one report has pointed to “under-investment”, “over-regulation”, and “excessive competition” as the three main factors behind the declining competitiveness of our corporations on the global stage. So why have more acquisitions, mergers, and industry reorganizations not taken place amidst this heightening sense of crisis caused by excessive competition and declining competitiveness? Here I would like to examine the case further while also prescribing my own remedy for this particular situation.

Over the past few years, IN-OUT type of corporate acquisition has been particularly popular even in Japan, with somewhat escalated valuation, a sign of overpaying. In a way, this could be signaling a change in the mindset of corporate management from the defensive to the offensive as Japan is now steering from deflation toward inflation. Although one should restrain from too much optimism as the end result is yet to be seen, the fact that the management circle is ready to take the “offensive” stance is at least a promising progress.

Having said that, excessive competition still remains a severe problem for a number of matured industries in Japan. Apart from some of the asset heavy industries which was hard hit due to fierce catch up from overseas players (Steels, consumer electronics, semi-conductors, and oil refineries etc), we have not witnessed impressionable reorganization among large sized corporations recently. We do have an overall impression that each company is trying its best to bulk up “muscles” by pursuing measures such as cost reduction. However, in reality, the profitability of Japanese corporations is still below the general standard of a developed country. Apart from the more obvious issues, for example, the inflexibility in hiring, my suspicion is that underlying problems such as an overcrowded corporate sector are perhaps doing more damage in this instance.

Consider construction industry, for example. Despite the fact that domestic construction investment has already halved since its peak (84 trillion yen) in 1992, the number of construction companies continued to grow until 2000, and has declined only 22% since then. In other words, there are increased number of construction companies now left to struggle over an ever-shrinking pie. Of course, at the moment the industry is riding on the wave of the 2020 Olympic Games, but what will be their situation thereafter?

While this is solely my personal opinion, I would like to prescribe now my own remedy for encouraging management to take more positive stance towards industry reorganization (M&As, spin-outs or divestment). The idea is extremely simple; in fact, it has already caught the attention of institutions such as METI, observing their various proposals thus far. In short, my suggestion is to facilitate an increased ownership of company stock by the management, through either long-term stock option or restricted shares.

Although M&As and various business combinations should be determined by a highly professional judgment by the board of directors, the process itself is often hindered by somewhat potentially emotional judgment made by the executives on the target company who fears they might be demoted or even be fired. I wonder how many of these home-grown executives would be willing to accept terms that would likely lead to surrendering their current positions without any personal emotion if so required by an acquisition deal that promises to “maximize company value and provide the most favorable terms for its employees”. More often than not, these executives would either try to change the conditions on these proposals behind the door, or they would reject the deal altogether, citing reasons such as, “no one else would be able to take responsibility for the acquisition if we are gone” or “It will be seen as bad from employees if we are cashing out and retiring”.

I even doubt whether I could willingly sever myself from a company that I love if put under the same situation with a salary level and ownership of typical Japanese companies. Although the circumstances surrounding each and every individual are different, it is only natural for any human being to react in this way when their future stability is in question. Of course, quite obviously, a corporate environment like that in the United States, where more than half of the board directors are from the outside, is more likely to deliver highly rational decisions without unnecessary sentiments. In fact, the call for a way or a code of conduct to eliminate such personal emotion in the board room has been reverberating quietly in the discussions on corporate governance in Japan, under the corporate governance code. However, despite a recent sharp increase in the number of outside directors, it is only true that whether a rational decision can be reached in the board room in extreme situation such as M&As, is still much left to the discretion of each individual. This problem is a reflection of the fundamental dilemma behind capitalism (the problem of fiduciary) that has been hinted by Professor. Katsuhito Iwai on various occasions.

So, as a matter of fact, I believe the simplest and the most effective method to rule out personal emotion without getting entangled in any kind of complicated ethical or philosophical debate would be for directors and executives “to own significant amount of company shares”. First, we must recognize the corporate climate faced by the board of directors in Japan. Unfortunately, according to a survey published by the consulting firm Towers Watson, the remuneration package for a director in a listed company in Japan is still far below the global standard, as well as majority of it is in the form of fixed salary, with only very small incentive based bonus. To be fair, the hidden reason that the remuneration system has evolved in this manner has, undoubtedly, much to do with the tax systems in Japan.

In any case, for an in-house director who has sacrificed much for the company for a less than satisfactory salary that has left them with practically no savings at all, a sudden dismissal would inevitably elicit all kinds of anxieties, as they are now forced to confront the difficulty of starting a second career with limited skills and old age. However, for example, if each director owned more than five times of their annual income from the company, then large part of their anxieties deriving from future potential financial stress may be relieved, and can make a judgment based on fair and balanced opinion as both owner and as the long-time manager of the company.

Rewarding more share based compensation not only increase the incentive of directors and key employees but also potentially removes some of the hidden behavioral biases in the board room discussion. METI, as well as the National Tax Agency, have also removed additional burdens from the shoulders of company directors recently by a modification of tax regulations surrounding restricted stock, so that the issuance and allocation of company shares have also become more straightforward. The immediate effect of this measure is obvious in that the directors themselves are now shareholders and there would be clearer and stronger alignment of interest between shareholders and the management team. As for the future, I believe this could be the true catalyst for reducing excessive competition and increase profitability for domestic companies through a much needed industry reorganization in Japan.

An industry reorganization could bring along a virtuous cycle, with greater competitiveness, increased profitability, and better bonus package (stock option is also a good incentive for employees in a new company who have just been nominated to join the management level) for the ones who survive (employees in the company who lost would not be worse off as they would, if work hard and generate results, also join this better profitability and better package). This is exactly the so-called “good inflation” advocated by Abenomics. Under a concept named “golden parachute”, companies in the United States are known for demanding large sums of severance in the event of a hostile takeover where directors and executives are forced to leave. Although regarded by some as an unscrupulous anti-takeover strategy, this could actually ensure that rational decisions would be made by directors from the acquired side as future anxieties have all been eliminated. While there are criticism that golden parachute discouraged more M&As to occur there are counter arguments that it has actually facilitated the M&As in the US, as mentioned in the glossary of Nomura Securities website.

There are a few things that can be seen as the reason for Japanese industry’s lack of dynamism and lack of labor force velocity; Employee training focusing on accumulating internal knowledge, seniority based wage system, etc. However, come to think of it, M&As and industry consolidation has the power to overwrite all of such, as it will lead to creation of new entities and can be used to implement new rules. As a small, but rational investor, I am excited to observe how my hypothesis of ‘ownership increase would lead to more M&As’ may turn out in the next 3- 5 years. It does not require Abenimics theme being shouted upon you, or corporate directors unwillingly
forced to raise wages just in order to try to cause inflation. Dynamic corporate reorganization would be facilitated based on change in board room behavior. I feel it is silly to discuss the right or wrong of “Shareholder sovereignty” or about “Principal and agent issues” because there would always be something good and bad about it because the idea itself is created by human being. I would rather make this discussion obsolete by taking away the barriers between the shareholders and the board by making all of them decent shareholders. Well, we have time, so let us see. Let us first start from designing the remuneration system so that directors would receive more share based compensation. I am looking forward to the changes.

Yuya Shimizu