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28 October 2019
Certain large corporate groups in Japan have been criticised for having antiquated group governance structures that do not provide adequate protection against corporate malfeasance. It has been recognised that poor group design and governance often play at least an indirect role in white collar crime.
As part of ongoing efforts to address these issues, the Ministry of Economy, Trade and Industry (METI) published the Practical Guidelines on Group Governance Systems (GGS Guidelines) on 28 June 2019.(1) The GGS Guidelines complement the Practical Guidelines for Corporate Governance Systems (CGS Guidelines), which were published in March 2017 and subsequently updated in September 2018.(2)
The CGS Guidelines were created as part of the Cabinet Office's Japan Revitalisation Strategy 2016, which aimed to promote the "enhancement of corporate value through... corporate governance reforms".(3) The CGS Guidelines set out specific actions that Japanese corporates may take in order to implement the primary principles contained in the Corporate Governance Code 2015.
The purpose of the GGS Guidelines is to provide guidance to corporates operating within a group structure by building on a series of 'ideal approaches' to the design of corporate governance systems contained in the CGS Guidelines. The thinking is likely that groups with robust governance structures are more likely to have good corporate cultures which should help to protect against the risk of inappropriate management and conduct.
As Japan's population continues to shrink, overseas markets are becoming more significant to Japanese corporates looking for growth, and creating more effective group governance structures in line with international best practices is an increasingly important issue. As such, the GGS Guidelines contain a number of suggestions in this regard.
The GGS Guidelines provide 'ideal approaches' with regard to:
The GGS Guidelines are aimed at listed companies with subsidiaries (particularly large groups with significant operations overseas), but many of the recommendations are equally relevant to smaller corporate groups with primarily domestic operations.
A few themes emerge in the GGS Guidelines, including:
Both themes are discussed further below.
'Group design' is the process of determining the structure and distribution of authority within a corporate group and is the basis upon which effective group governance is built. The GGS Guidelines suggest that companies should consider the following when seeking to design an effective group structure:
In addition, the GGS Guidelines recommend the following initiatives to help mitigate the risk of inadequate oversight of subsidiaries:
Business portfolio management
In a diversified company that operates multiple businesses, it is important to optimise management resources by implementing effective business portfolio management, such as strengthening core businesses, nurturing next-generation growth areas and withdrawing from under-performing businesses after carrying out an appropriate assessment. The GGS Guidelines highlight the following governance points in relation to business portfolio management:
Given that corporate compliance issues can have a destructive impact on shareholder value, compliance risks should be mitigated to the extent possible by effective risk management (so-called 'defensive' governance) – for example, the 'three lines of defence' model – and by effective crisis management. Equally, in order to maintain and improve shareholder value over the medium to long term, business operations should be conducted in a flexible manner based on appropriate risk-taking (so-called 'offensive' governance).
Risk management – three lines of defence
The GGS Guidelines stipulate that the three lines of defence model should be considered in the construction and operation of an internal control system. The model consists of:
The first line (business divisions) has the following areas of responsibility:
In relation to the second line (legal and compliance divisions):
In relation to the third line (internal audit divisions):
The GGS Guidelines provide a number of recommendations for responding to crises effectively:
Nomination and compensation of subsidiaries' management
Parent companies have the right to decide the composition and compensation of a subsidiary's senior management team provided that they are a controlling shareholder. The GGS Guidelines stipulate that decision making by the parent should be exercised to further the integrated management of the group and maximise shareholder value. In this regard, the GGS Guidelines state that the appointment and compensation of the senior management of major wholly owned subsidiaries should be included in the scope of deliberations by the board of directors and highlight the following measures:
These initiatives are expected to strengthen the sense of unity among the directors and employees of a parent and its subsidiaries as a group, maximise group synergies and facilitate communication.
Governance of listed subsidiaries
For listed subsidiaries, special consideration is required since there is a risk of conflicts of interest between the parent, which is the controlling shareholder, and other shareholders. As a general consideration, the GGS Guidelines highlight that parents should keep under review whether it is optimal for a listed subsidiary to maintain its public listing from the perspective of improving the corporate value of the group and improving capital efficiency.
Group design and business management
The GGS Guidelines state that group design needs to find the appropriate balance between centralisation and decentralisation. Recent high-profile compliance failures at group companies in Japan have been partially caused by reductions in the resources of parents' legal and compliance functions and the decentralisation of decision-making authority with an emphasis on speeding up decision making and reducing costs, resulting in inadequate supervision and management of subsidiaries. This highlights the importance of establishing a system to appropriately manage and supervise subsidiaries when designing a group structure. The challenge in doing this is maintaining both effective governance and operational flexibility. Continuous monitoring of the structure is necessary to ensure that the right balance is being struck.
The specific initiatives for business portfolio management in the GGS Guidelines were not part of the CGS Guidelines published in 2017. There is an increasing recognition that inadequate business portfolio management can lead to the institutionalisation of low-growth and low-profit businesses. This, in turn, may create compliance risks, such as inappropriate pressure on officers and employees in these underperforming divisions, which can result in a short-term pursuit of profitability at the expense of compliance considerations.
The GGS Guidelines recommend the implementation of the three lines of defence model. In Japan, although listed companies usually have legal, compliance and internal audit divisions that work with and oversee business divisions, in some cases, the relationship between the second and third lines and the business divisions can be dysfunctional. Some companies have historically underinvested in the functions that support and monitor the business units and, consequently, there can sometimes be a lack of talent in these areas. Therefore, to help mitigate legal and compliance risk that may arise in the business divisions, it is crucial to:
The GGS Guidelines leave open the possibility that a board of directors may wish to establish a third-party committee at arm's length to conduct an investigation. While a report produced by such a committee may be protected by legal professional privilege outside Japan if the committee is comprised at least partially of lawyers, the successful assertion of privilege by the company over any report produced is not guaranteed, particularly if large parts of the report are published. Therefore, commissioning this kind of report can create new risks for a company in any follow-on civil litigation, particularly as reports prepared by committees operating at arm's length sometimes contain fundamental inaccuracies since the testing of evidence and conclusions are typically not as robust as the process undertaken by outside counsel who have day-to-day contact with a company.
For further information on this topic please contact John Lane or Yu Yuasa at Nagashima Ohno & Tsunematsu by telephone (+81 3 6889 7000) or email (firstname.lastname@example.org or email@example.com). The Nagashima Ohno & Tsunematsu website can be accessed at www.noandt.com.
(1) Further information is available here.
(2) Further information is available here.
Akiko Inoue assisted in the preparation of this article.
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