Relation between Top Executive Compensation Structure and Corporate Governance: Evidence from Japanese Public Disclosed Data

• Date: 01 November 2012
• Author: Hideaki Sakawa,Keisuke Moriyama,Naoki Watanabel
• Published date: 01 November 2012
• DOI: http://doi.org/10.1111/j.1467-8683.2012.00928.x

Relation between Top Executive Compensation

Structure and Corporate Governance: Evidence

from Japanese Public Disclosed Data

Hideaki Sakawa*, Keisuke Moriyama, and Naoki Watanabel

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This paper explores the incentive structure of executive compensation in Japan in 2010, when

Japanese individual executive compensation data for those receiving more than 100 million Japanese yen were made public

for the f‌irst time. This public disclosure enables investigation of the relation between cash-based and stock-based individual

incentive compensation and corporate governance mechanisms in Japan.

Research Findings/Insights: Results show that 1) the bank ties do not substitute for incentive compensation, unlike in the

1990s in Japan, when they were effective for solving agency conf‌licts; and 2) the role of incentive compensation is found

to be effective for f‌irms with a higher degree of foreign ownership. We also examine the role of the new internal control

mechanism of f‌irms with a committee system which includes a compensation committee for facilitating incentive compen-

sation. However results show that internal control systems of f‌irms with committees only facilitate short-term incentive

packages because they fall into short-termism as a result of their short duration of a single year.

Theoretical/Academic Implications: Theoretically, bank ties do not contribute as a substitute for incentive compensation to

align management and shareholder interests under a Japanese relationship-oriented system. This implies that Japanese

relationship-oriented systems would have been weakened by solving agency conf‌licts. Furthermore, f‌irms with committee

systems can no longer provide managerial incentives because of the short-termism of committee members.

Practitioner/Policy Implications: This study provides insights for practitioners and policymakers interested in execu-

tive compensation structures in any country where corporate governance is reformed to introduce Anglo-American

mechanisms.

Keywords: Corporate Governance, Bank Ownership, Executive Compensation, Japan

INTRODUCTION

In a contemporary public f‌irm in which ownership and

management are separated, executives tend to pursue

their own interests and neglect those of shareholders. Direct

linkage of executive compensation to f‌irm performance pro-

vides incentive for executives to exert greater effort (Core &

Guay, 2010; Core & Larcker, 2003; Murphy, 1999). In this

view, the incentive structure of executive compensation is

important for inducing better performance and for prevent-

ing agency problems. Most empirical evidence related to

executive compensation is centered on the US because the

disclosure of top executive compensation data has been

mandated in the US, unlike many other countries. Japan’s

new rule changes encouraging disclosure urged listed f‌irms

to disclose publicly “individual executive compensation

which exceeds 100 million yen” after f‌iscal year 2010 (Finan-

cial Times, 2010b). Using those data, we specif‌ically examine

how different corporate governance mechanisms can be

expected to affect Japanese individual top executive incen-

tive structure, which differs markedly from thatof any other

developed country.1

Corporate governance mechanisms are important for con-

trolling executive compensation. Even in US f‌irms, greater

agency problems are attributable to weaker governance

mechanisms, as ref‌lected in CEOs’ higher compensation

than their f‌irms’ performance can explain (Core, Holth-

ausen, & Larcker, 1999). Other previous studies, such as

those by Wiersema and Bantel (1992) and by Antia, Pantza-

ils, and Park (2010), specif‌ically examine CEO characteristics

*Address for Correspondence: Hideaki Sakawa, Graduate School of Economics,

Nagoya City University, 1 Yamanohata, Mizuho-cho, Mizuho-ku, Nagoya 467-8501,

Japan. E-mail: sakawa@econ.nagoya-cu.ac.jp

593

Corporate Governance: An International Review, 2012, 20(6): 593–608

© 2012 Blackwell Publishing Ltd

doi:10.1111/j.1467-8683.2012.00928.x

such as CEO age and tenure, and analyze the linkage

between their characteristics and changes in business strat-

egies or CEOs’ short-term horizons. In other Anglo-Saxon

countries, the reporting of board members’ compensation

started in 2001 (Conyon, 2001). Conyon and Murphy (2000)

examined differences in pay-for-performance relations. In

Germany, a country with Japan-like bank-centered corpo-

rate governance, disclosure of individual executive compen-

sation began in 2002, but disclosure had not advanced

smoothly after three years (Chizema, 2008).

We address the empirical question of whether or not the

Japanese executive compensation package can provide

adequate incentives, which helps to provide a clue as to how

compensation contract designs differ among nations. Japan

is traditionally regarded as having a “relationship-oriented”

system, which differs from a “market-oriented” system such

as that of the US (Aoki, 1990; Aoki, Patrick, & Sheard, 1994).

However, after the deregulation of f‌inancial systems and

corporate governance reforms, Japanese corporate gover-

nance can best be regarded as a “transition” system. As

Hoshi and Kashyap (2010) point out, commercial banks

were limited in their use of “mochiai” or cross-shareholding

by deregulation. After corporate governance reforms, Japa-

nese f‌irms have been able to adopt a new board system with

three committees, as in the western system, which differs

from a “traditional” board system with statutory auditors.

We approach this question in relation to Japanese f‌irms

because Japan is suff‌iciently different economically and cul-

turally from the US to yield meaningful results from these

analyses.2This paper f‌irst presents an examination of incen-

tive compensation structures including stock option values.

It sheds light on stock-based incentives in Japan under its

peculiar corporate governance mechanisms. The strength of

this approach can be summarized in the following two

points. First, individual CEO compensation data are avail-

able. In Japan, executive compensation and individual CEO

compensation data have not been available since 2009, as in

most Asian countries. Full disclosure of compensation is not

pervasive in Asia. As described in Sheu, Chung, and Liu

(2010), Taiwan has adopted a gradual enforcement of com-

pensation disclosure. This paper can also provide important

implications for corporate governance in Asian countries.

Second, we can use the respective amounts of individual

executive compensation data, unlike previous Japanese

studies such as those of Kato (1997) and Basu, Hwang, Mit-

sudome, and Weintrop(2007). Individual executive compen-

sation data were available for the f‌irst time for f‌iscal year

2010. Detailed Japanese executive compensation data consist

of the following four components: (1) cash salary, (2) cash

bonus, (3) value of granted stock options, and (4) other tem-

porary income. We can distinguish the respective amounts

of the four compensation components precisely for indi-

vidual directors who receive more than 100 million yen.3

The empirical f‌indings can be summarized as follows.

Regarding traditional corporate governance, bank relations

facilitate incentive compensation instead of the direct moni-

toring of bank monitors. Transitions in corporate gover-

nance, such as the degree of foreign ownership, facilitate

long-term incentive compensation. New Japanese internal

control systems of “f‌irms with committees” do not facilitate

long-term incentive packages and only facilitate short-term

incentive pay packages because they fall into short-termism

because of their short duration of a single year. Finally,

regarding executive characteristic variables, the top execu-

tive tenure is negatively related to the incentive ratio, which

is consistent with the managerial entrenchment hypothesis,

as presented in the US evidence of Berger, Ofek, and

Yermack (1997).

The remainder of this paper is organized as follows. First,

this paper presents a description of Japanese corporate gov-

ernance mechanisms and executive compensation practices.

Next, we develop the empirical hypotheses and introduce

the estimation models. We then present an explanation of

the data and descriptive statistics and verify the mean dif-

ference tests. The empirical results of the estimation models

are then interpreted. Finally, we conclude this paper.

JAPANESE CORPORATE GOVERNANCE

AND COMPENSATION

Japanese Corporate Governance Mechanisms

Japanese corporate governance was widely characterized as

a “relationship-oriented” system during the 1990s (Aoki,

1990; Aoki et al., 1994; Sheard, 1994). After deregulation of

f‌inancial systems, known as Big Bang deregulation, and cor-

porate governance reforms, the traditional governance

system weakened and Japanese f‌irms became able to replace

traditional board systems with other systems with institu-

tions such as statutory auditors with three committees,

known as Western systems. In this section, we introduce the

traditional corporate governance mechanism and the subse-

quent transition of corporate governance mechanisms.

The salient features of traditional governance systems are

exemplif‌ied by those of six business groups, or f‌inancial

keiretsu, with cross-shareholdings among business group

members and bank ties (Hoshi & Kashyap, 2001). The bank

ties represented greater shares of bank ownership, and

bank-appointed directors played a monitoring role (Hiraki,

Inoue, Ito, Kuroki, & Masuda, 2003; Morck & Nakamura,

1999; Morck, Nakamura, & Shivdasani, 2000). Hoshi and

Kashyap (2010) describe that after the deregulation of f‌inan-

cial systems, known as Big Bang deregulation, commercial

banks were limited in their use of “mochiai” or cross-

shareholding by the Banks’ Shareholding Restriction Law in

September 2001.

Previous studies have pointed out the fundamental

change of ownership structure that took place in Japanin the

2000s. Miyajima and Kuroki (2007) reported thatthe stock of

“mochiai” or cross-shareholdings started to be sold from

1997. Foreign ownership soared thereafter and a “market-

oriented” system has been introduced gradually into

Japanese corporate governance mechanisms. After corporate

governance reforms, the commercial code admits Japanese

f‌irms’ adoption of three committees, for audit, nomination,

and compensation.

Unlike traditional Japanese companies with statutory

auditors, Japanese f‌irms with committees are expected to

take a monitoring role and to delegate the management role

to executive off‌icers. The structure of the board of directors

was changed after amendment of the Commercial Law in

594 CORPORATE GOVERNANCE

Volume 20 Number 6 November 2012 © 2012 Blackwell Publishing Ltd