How investors are tracking progress on Japan’s efforts to unwind cross-shareholdings

Over the last decade, investors have observed the positive impact of corporate governance reform in Japan. However, in some areas the speed of progress has remained slow. This has been particularly noticeable with the persistence of cross‑shareholdings—a practice that involves a publicly traded company holding shares in another listed company. Cross‑shareholdings are problematic for two reasons. Not only do they have a potentially detrimental impact on capital efficiency, but the presence of “friendly” strategic shareholders can also insulate management from the need to pay attention to the complaints of minority shareholders. Investors are asking Japanese companies to set targets to sell off—or “unwind”—these cross‑shareholdings, but despite progress, the unwinding process has called into question the visibility of the use of proceeds and how Boards are overseeing the journey.

Governance reforms drive institutional interest in Japan

For more than three decades, the return on equity³ for Japanese mid- and large‑cap companies has remained lower than those of their U.S. and European peers, according to research by MSCI.⁴ However, over the last two years, the Japanese stock market has outperformed global equity markets. We believe part of Japan’s increased attractiveness to institutional investors can be attributed to the progress of the country’s governance reforms.

"We believe part of Japan’s increased attractiveness to institutional investors can be attributed to the progress of the country’s governance reforms." 
Jocelyn Brown, Head of Governance, EMEA and APAC

Following several revisions of the Japanese Stewardship Code and the Corporate Governance Code, in addition to pressure from investors, we have seen incremental progress on board composition over the last few years. This has been particularly evident with the appointment of more independent directors and more female directors. However, we have seen a slower pace of change on cross-shareholdings.

How cross-shareholdings can undermine return on capital

In March 2023, the Tokyo Stock Exchange (TSE) requested that all listed companies on its prime and standard markets⁵ take “action to implement management that is conscious of cost of capital and stock price.” At the time, nearly half of all Japanese listed companies had a price‑to‑book (P/B) ratio below 1.⁶ Our portfolio managers, concerned by the number of companies that did not apply sufficient capital management discipline, welcomed the TSE action.

After an initially slow response to the TSE’s request, the pace accelerated in January 2024—when the TSE began reporting a list of companies that had disclosed information in accordance with the request. The following month, the Financial Services Agency (FSA) called on Japanese non‑life insurers to accelerate their sell down of cross‑shareholdings. By the end of May 2024, 72% of prime market listed companies and 30% of standard market listed companies had either disclosed information regarding the “action to implement management that is conscious of the cost of capital and the stock price” or said that such disclosure is “under consideration”—up from 49% of prime listed companies and 19% of standard listed companies at the end of December 2023.⁷

The TSE recommended that companies analyze the current situation, plan and disclose, then execute on the initiatives. TSE research⁸ analyzing the first four months of company responses found that the improvement initiatives in companies with P/B ratios of less than 1 included investing for growth, strengthening shareholder returns, sustainability initiatives, and a review of the business portfolio. Yet much of the investor focus has been centered on the reduction of cross‑shareholdings. This is partly because many investors, including TRPA, have included a voting guideline against top management if the proportion of cross-shareholdings to net assets is over a certain threshold (typically either 10% or 20%) in their house voting policies.

TRPA incorporated the voting guideline in 2022, which means there have now been three annual general meeting (AGM) seasons where the voting guideline has been in effect. After the first wave of votes against management in 2022, we saw companies proactively engaging in the off-season in 2023 and 2024 to set out how they planned to respond to investor concerns. The equity analyst who owns the relationship with the company will often join the meeting and discuss the company’s approach to capital management, which informs how we vote at the next AGM.

Cross-shareholdings are particularly prevalent across banks and insurers
While cross-shareholdings exist across many listed Japan corporates, the practice has been particularly prevalent across Japanese banks and insurers. Although there is progress, the current size of exposure and pace of reduction remain potential areas of contention. Given the need to hold Board management accountable for progress, it is important for investors to fully assess starting positions and expected progress for banks, allowing for more accurate benchmarking against peers.

Market practice is fast evolving

We recently conducted analysis that showed many companies are publicly disclosing unwinding targets, with some seeking to reduce the ratio of cross-shareholdings to net assets below 20% or 10%. Others have opted for an absolute reduction target. The few companies with no unwinding targets are now obvious laggards. Crucially, progress against the targets set will require careful monitoring and engagement by investors for several years. Setting the target is a positive first step, but companies must deliver an orderly unwinding during which they serve as responsible stewards of capital. 

To help companies understand investors’ expectations, in April 2024, we signed on to an Asian Corporate Governance Association (ACGA) open letter on the topic of cross-shareholdings, along with other interested investors, which made several recommendations relating to disclosure and oversight. The ACGA open letter sets out how strategic shareholdings can have a detrimental impact on companies’ capital efficiency. A block shareholding can also entrench management by not voting against directors despite poor performance. The presence of affiliated outsiders on the Board may lead to a conflict of interest between the strategic investor and other minority shareholders, where the independent director may prioritize the commercial interest of the strategic investor over other minority shareholders.

One of the key recommendations is that companies undertaking divestment of their strategic investments should articulate their plans for the proceeds from these divestments, ideally as part of its action plan in response to the TSE’s cost of capital guidelines.

Reclassification can result in “hidden” holdings

In some cases, votes against management on the issue of cross-shareholdings are having a meaningful impact on levels of support. As a result, we believe that the pace of change on the unwinding of cross‑shareholdings will accelerate over the next year.

Our analysis suggests that, over the last five years, the number of reclassifications (where shares held as cross-shareholdings are reclassified to shares held for pure investment purposes) peaked in 2022. This timing suggests that companies may have been undertaking reclassification exercises seeking to avoid votes against top management, given this is the year the voting guideline was introduced in the Japanese market. 

Another potential explanation is that companies were reviewing their approach to cross-shareholdings in 2022 to take account of the focus on cross-shareholdings in the Guidelines for Investor and Company Engagement, which accompanied the 2021 revision of the Japanese Corporate Governance Code. The FSA’s Action Plan for Corporate Governance Reform 2024 flags reclassification under point 6, resolving market environment issues, and in November 2024 the FSA announced that it would require additional disclosure for cross-shareholdings reclassified as shares held for pure investment purposes in the past five business years.

In summary, our experience in the Japanese market is that when investors, regulators, and stock exchanges communicate clear expectations, we see issuers respond relatively quickly and positively. This happened in relation to Board outsiders and independence. It also happened with gender diversity on Boards. Now we can see a similar journey unfolding on the issue of cross‑shareholdings. As a result, we expect the changes being undertaken by companies could increase the number of attractive investment opportunities in Japan.