Corporate Governance Reform in Japan

James Hawrylak

Head of Asian Marketing and Operations

May 27, 2010

jhawrylak@glasslewis.com

+81 (0)80 3601 5391

On the way to better governance

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Today’s agenda: governance reform underway in Japan

Glass Lewis’ Policy on Election of Directors – Seeking greater independence

Recent Developments – Defining Japanese corporate governance

Trajectory – A future full of promise while uncertainty remains

Appendix – the Nature of the Japanese Proxy Season

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TOPIX 150 2008 TOPIX 150 2009 TSE 1st Section 2008 TSE 1st Section 2009

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Board entrenchment is common

“Outsider” not necessarily “independent”

Lack of independent board representation

Slow trend towards increased board independence

* Minimum of 2 independent directors ispragmatic and an achievable level of

independence that serves as a minimal safeguard of

shareholder rights

Externality and Independence Rates

Independence in the market today

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Glass Lewis revised policy for board independence: a much needed push forward

Independence standard strictly defined

Minimum of 2 independent directors

Protest vote against most senior member of the board (I.e., chairman or CEO)

* In absence of standards set by market, we set our own,

but continue to review boards on a case-by-case basis

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Reactions to revised policy on independent director representation

“Proxy Adviser Targets Japan Inc.”

“Glass Lewis & Co. says it will raise bar for Japanese companies…recommending investors vote against the re-election of as many as 90% of Japanese chief executives for slack corporate governance… The move comes as a broader range of investors are critical of the state of Japan’s corporate governance… Even the Japanese government is…looking into how to improve corporate governance, with a particular focus on increasing the number of independent directors.”

The Wall Street Journal, February 25, 2009

“Enough is Enough”

“Glass Lewis & Co has recommended that… its clients vote against the re-election of the chairman of the board (or if that position does not exist, the CEO) if the board does not have a minimum of two independent outside directors. The recommendation would effectively mean a “No” vote at 90% of the companies that Glass Lewis covers in Japan… It believes that voting against chairman and CEOs would send a strong message to companies and regulators that change is urgently needed.”

ACGA Regional Briefing, April 2009 “Glass Lewis was one spark that set off these fires of change, by boldly implementing a policy to vote against the re-election of the top person on any board slate in Japan that does not have two or more independent outside directors.”

The American Chamber of Commerce of Japan, November 2009

Defining Japanese Corporate Governance

Recent Developments in Governance Reform

Corporate governance overhaul

2009

Ministry of Economy, Trade and Industry (METI)

Financial Services Agency (FSA)

Tokyo Stock Exchange (TSE)

2010

Financial Services Agency (FSA)

2012 (?)

Democratic Party of Japan (DPJ)

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The Corporate Governance Study Group ReportPublished: June 17, 2009 METI:

“Independence” on the board: issues and analysis– The current law defines “externality” but not “independence”

– Non-independent non-executive board members can still make valuable contributions to a firm and thus, diversity in externality should be accepted

– Report confirms the need for some independent board representation

The report promotes independence on company boards, but cautiously– There is a potential tradeoff between increased independence and the efficacy of

management, and each company should be allowed to adopt the most effective structure within the context of its business

– “Comply-or-explain” model. Urges stock exchanges to make rules

The Study Group’s model of good governance– There should be at least one independent director or statutory auditor on each board

– Two-tier boards are recommended to either:

i. Appoint at least one outside director and disclose the company’s corporate governance system; or

ii. If no outside director is appointed, explain how the company’s own model of corporate governance will be effective

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Report by the Financial Systems Council’s Study Group on the Internationalization of Japanese Financial and capital MarketsPublished: June 17, 2009

Review of issues to improve corporate governance at public companies

Issues concerning capital policies for companies

– Private placement of securities: increased disclosure to prevent abuse, and significant placements should require review by the stock exchange and independent third party’s opinion

– The stock exchanges should monitor minority squeeze-outs to protect minority shareholder rights

– Principles of corporate governance should be applied across group companies

– Practice of “Oyako-jojo” should be reviewed and rules developed to prevent abuse of power by parent entity

– Suggests disclosure and unwinding of cross-shareholdings

Issues concerning monitoring of management by shareholders

– Exercise of voting rights a major element of fiduciary duties of institutional investors

– Institutional investors should disclose proxy voting guidelines and voting results

– The use of ICJ platform for electronic voting should be promoted

FSA:

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FSA: FSC recommendations

Structural aspects of corporate governance

– Elect one or more independent outside directors

– Joint monitoring of internal control and management by independent outside directors and statutory auditors

– Strengthen the function of board of statutory auditors

– Maintain adequate human resources and infrastructure to support statutory audit

– * Appoint finance/accounting experts to statutory audit board

– Give authority to appoint audit firms and set their fees (directors currently have this authority)

– Disclose relationships between the company and outside directors and statutory auditors

– Improve disclosure on remuneration types and policies

Framework to implement governance discipline

– Stock exchanges have the mission to ensure their rules provide a high standard of corporate governance

– Urging stock exchanges to propose a best practice model

– Disclosure must be improved to ensure effectiveness of market-based corporate governance

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TSE Restrictions on private placementsImplemented: August 24, 2009

Dilution 300%+TSE to review whether the placement harms the interests of shareholders

Change in Control

TSE to review transaction between company and controlling shareholders

Issuers are required to obtain: (i) fairness opinion from independent third party; or (ii) prior shareholder approval

Dilution 25%+Issuers are required to obtain: (i) fairness opinion from independent third party; or (ii) prior shareholder approval

All Private Placements

Issuers are to confirm the investor’s availability of funds

Issuers must disclose the rationale for the issue price

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TSE

Plans to Enhance Corporate Governance Issuers are now required to appoint at least one independent director or independent

statutory auditor, free of conflict

– Relationships and affiliations of outside directors and external statutory auditors should be clearly disclosed

Issuers must explain their system of corporate governance and how it will be effective

Improving Disclosure– Recommend disclosure of AGM voting results by the issuers

– Promote and facilitate the use of ICJ platform (may mandate it eventually)

– Facilitating adoption of IFRS

– Disclosure of cross-shareholding

– Disclosure of the proxy materials through TSE site

Improving Governance of the Group Companies– Principles of corporate governance will be applied to the whole group

– Important management decisions by subsidiaries and their rationales should be disclosed and explained to parent company’s shareholders

Listing System Improvement Action Plan Published: September 29, 2009 (cont’d)

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FSA

Executive Compensation

– Disclosure of individual pay of directors, statutory auditors and executives making more that JPY 100 mn

– Breakdowns of different components of compensation such as bonus, stock options, retirements, etc.

– Compensation policy and the metrics used in determining compensation

Cross-shareholdings

– Disclosure of the reason why a company holds marketable securities and the value of it for 30 largest securities as well as any security that exceeds 1% of paid-in capital

Voting tallies of each proposal at shareholder meetings

Draft changes in disclosure requirements for FY ending March, 2010: February 12, 2010

Financial Services Agency

New disclosure requirements

Disclosure on executive pay– Traditionally, no meaningful compensation disclosure existed in Japan

– Companies will be required to disclose individual pay of board members receiving more than ¥100 million in total compensation

– Most board members receive less than ¥100 million in total pay

– May encourage smaller pay to avoid disclosure

Cross-shareholding and investments in other securities– Companies must disclose greater details regarding stocks they own in other public

companies and must provide rationale for making these investments

– But there are some loopholes…

Vote results– Companies must disclose the voting result of a shareholder meeting

The details of the Act have not been publicly disclosed, but it is rumored to consist of significant changes including:

Employee representation on the board of statutory auditors

Minimum of one-third independent board

Stricter definition of “outsider”

Possible abolition of Oyako-jojo (parent-subsidiary listings)

Strengthening of the rights of statutory auditors

Four-month window between FYE and shareholder meeting to disperse shareholder meeting concentration

Focus on stakeholders rather than shareholders

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DPJManifesto proposal: enact a “Public Companies Law”

Implementation: Not yet determined (2012?)

Trajectory

A future full of promising developments in Japanese governance

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A pivotal time for Japan:Looking ahead at the next 6-12 months

Corporations will be asked to “explain” corporate disclosure and independence standards

– Shareholder scrutiny likely to intensify next year

– Those companies that fail to provide compelling rationale could become targets of shareholder activism/engagement

– Engagement between issuers and investors will likely increase significantly

Shareholders will continue to closely monitor:– Board independence

– Compensation practices

– Rationale of whether governance structure adopted by a company is justified or not

Need for executive and director talent is imminent– Japan needs to build a pool of well-qualified individuals for corporate boards through training

and education

– An infrastructure to help find the best talent for the position is necessary step in building a talented pool

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Conclusions: Improvements abound with a greater sense of urgency

Promising signs of change, but what will it mean to the market?

Positives

– Addresses many of the systemic problems that have long been neglected

– Independence finally being defined with first steps in ensuring independent board representation

– Improved disclosure of cross-shareholdings, compensation, and AGM results

Negatives

– Proposed changes are modest (but still look to result in material change)

– In the face of Keidanren’s opposition, reforms may ultimately be significantly watered down

– Change comes so slowly that despite reforms, Japan may still get left behind in the competition for global capital

Continued slow pace of change and complacency is not an option

Appendix: the Nature of the Japanese Proxy Season

Challenges Exercising Voting Rights in Japan

Concentration of Meetings

Abnormal concentration that discourages shareholder participation

Meeting concentration is abnormally high

– This shows percentage of annual meetings held in a week within Glass Lewis’ total coverage of that market

– Japan has the highest concentration of meetings among more than 50 developed and emerging markets

Concentration of Meetings

Past “peak meeting days”

Most meetings held on the last Friday of the month

– In 2008, peak date was 6/27

– In 2009, peak date was 6/26

Information Disclosure and Proxy Voting

Limited time for analysis and voting

Inadequate information disclosure practice– Companies are required to disclose proxy statements 14 days before the meeting

– The overwhelming practice is to disclose documents 14 to 16 days before the meeting and earlier disclosure is still the minority

Slow adoption of electronic disclosure system– Traditionally, most proxy statements have been sent to shareholder via mail and no

electronic copy was made available

– Starting this proxy season, companies are required to file proxy statements with TSE and all materials should be accessible to all investors

Generally conservative voting deadlines– In most cases, investors must exercise voting rights 6 to 8 business days before the

meeting (10 to 12 calendar days before the meeting)

– This gives investors only few days to consider proposals and make voting decisions

80% of your portfolio companies will be holding meetings in June,many of which will hold AGM on the same day,

and you have only 2 to 4 days window to make voting decisions

2010 Projections

Peak dates and proxy filing projections

Two peak meetings days– 6/29: 41.7% of all June meetings

– 6/25: 23.3% of all June meetings

Filing of proxy statements– Most proxy statements will be filed between 6/7 and 6/11

– Many will also file on 6/14

Common voting deadlines– Meetings held on 6/25: 6/14~6/16

– Meetings held on 6/29: 6/16~6/18

Glass Lewis’ Proxy Paper production– Most reports will be published within 12 to 24 hours from the receipt of the proxy

statement

– Most reports will be delivered by Tuesday, 6/15

Key issues in 2010

Overall board independence– In light of the new independence requirement, there is a renewed interest on board

independence

– We will carefully evaluate independence of each board member

– However, we do not expect to see radical change in overall board independence

Renewal of poison pills– New adoptions will be extremely rare

– However, many poison pills adopted since 2007 are due for renewal and most require shareholder ratification for renewal

– Nearly 1 in 10 companies will seek shareholder approval for renewal this year

Increase in authorized shares– In 2009, we saw large-scale issuance of new stocks, and more companies are

expected to follow the suite

– To increase authorized shares and grant the company greater financial flexibility, many will amend their articles of incorporation

Shareholder initiatives

Shareholder proposals

Only a handful expected

– SHPs peaked in 2007

– Since the Lehman Shock, decline in confrontational proposals by activist funds (engagement preferred?)

– Capital issues are difficult to win

– In May, a fund made a proposal to prohibit poison pills at Matsuya

Most active are environmental and labor groups, not funds

– Many proposals relating to environmental and labor issues will be presented at electric power generators and railroad operators

Upcoming in 2010– At HOYA, a founding family member is

challenging the board