The Dirty Little Secret Stopping Foreign Shareholders from Exercising Their Voting Rights in Japan

Looking past the Kabuki (pun-intended) of Japan’s recent corporate governance awakening you will find an uncomfortable reality: not all shareholders get to vote. One would naturally assume that beneficial owners of common shares are entitled to vote at the annual shareholders meeting or whenever shareholder votes are called for. However, technically speaking, owning common stock in Japanese corporations entitles the shareholder of record to vote, not the beneficial owner. Often the shareholder of record is a third party such as a custodian or prime broker, which might not vote in the best interests of the ultimate beneficial owner. Sadly, if the beneficial shareholder wants absolute control of their vote, the process can be daunting if the shareholder is not domiciled in Japan.

Are you a Japan domiciled shareholder or not? The answer to this simple question is in fact extremely important when considering exercising the rights of shareholders in Japanese-listed companies, especially as it applies to the principles of shareholder equality. In other words, the boundary creates the difference between direct ownership and indirect ownership. As a result, a complicated, often opaque deeply layered ownership structure occurs. The complication is further obfuscated when coupled with the current time-honored hierarchical custodian system that causes shareholder equity to suffer by producing a variety of different voting status among similar shareholders. The beneficial shareholder might be known only by the sub-custodian’s name or the sub-custodian and the beneficial owner may both be listed as owners, but the voting rights of such a combination are open to interpretation by corporate counsel, not regulatory or shareholder law. There are several more combinations of custodial accounts, omnibus accounts, etc. but the important take away here is that shareholder equality suffers.

Without delving deeply into the mechanics Japanese equity trading, it is instructive to have an overview of the process to understand how certain types of shareholders might lose their voting power. Figure 1 illustrates the process by which a foreign fund (XYZ) buys shares of a Japanese listed company (ABC co.).

XYZ Fund sends their broker a buy order for 1,000 shares of ABC co. which is executed on the Tokyo Stock Exchange. The broker returns a trade confirmation to XYZ, which acknowledges the trade and sends settlement instructions to their custodian bank, State Street. State Street then instructs their local custodian, Mizuho Bank, to receive the shares. On the settlement date, the instructions from either side of the transaction are matched resulting in 1000 ABC shares being delivered to “Mizuho Bank - a/c State Street”. The 1000 shares of ABC Co. (with voting rights) are held in Mizuho Bank’s JASDEC account (the Japanese equivalent of DTCC*). The net effect? Mizuho Bank is the proxy for State Street, not XYZ. The name on the share register is not XYZ but the custodian, “State Street Bank and Trust Company, standing proxy for Mizuho Bank”.

The beneficial shareholder will generally use electronic proxy services to instruct the shareholder of record, in this case the onshore custodian or prime broker, as to how they wish to vote. And this is where the process gets disturbingly opaque.

*Depository Trust and Clearing Corporation

Similar but Different

In theory, electronic proxy service providers such as ADP and ISS enable foreign investors to vote on annual general meeting (AGM) agendas through custodian or prime broker’s websites. But are they actually voting? Here is where nuances in the legal structure become critically important, because the direct link between the beneficial owner and the company owned are still not recognized by those systems.

A foreign investor can instruct the custodian/prime broker to vote FOR, AGAINST or ABSTAIN on each agenda item through these portals. However, exercising a right and instructing a third party are two entirely different things. Figure 2 shows how the process actually works.

Because ABC’s dividend is not paid by the issuer directly but by the custodian, we have clear proof that the issuer does not recognize XYZ as a shareholder. And it follows that if a foreign investor is not a nominee shareholder, it means they don’t have requirements for shareholder assertion against ABC – precluding XYZ from exercising basic shareholder rights, such as attending the AGM as a shareholder or submitting shareholder proposals in the AGM.

Diverse exercise

Compounding the problem faced by non-voting beneficial owners is the comingling of shares held by global custodians in “omnibus accounts”. While custodians and sub-custodians keep books and records for millions of individual accounts, as long as there are no specific indications, the custodian usually holds securities in a disaggregated pool (Figure 3).

Voting instructions from unrelated shareholders are aggregated by the proxy service providers and are collected by the global custodian. When the votes are split, say in an extreme case 60% is FOR and 40% is AGAINST, the global custodian instructs the sub-custodian accordingly.

However, the Japanese Company Act allows diverse exercise for “persons who hold the shares on behalf of others” and the sub-custodian is interpreted as such a person. Since the sub-custodian has only one omnibus account, it’s easy to imagine them being overwhelmed by the sheer number of diverse exercises for each agenda for thousands of companies during the highly concentrated Japanese AGM season at the end of June.

While the facts are murky and dependant on each sub-custodian / prime broker’s policy and capability, but there must be some (or many) providers who cannot handle diverse exercise and opt for using a simple majority vote. If that is the case, a minority vote may not even be registered at the company’s AGM.

Global custodians may not disclose how aggregated results contribute their actual way of exercise, leaving investors to see only the final result of the vote in the AGM. There is at least a significant possibility that the 40% against vote would not be reflected in the above case at all. If negative votes were known and considered, over time more agendas might fail and that there is probably a chance that greater numbers of agendas would be voted down in the Japanese AGM process. The bottom line is, the voice of a foreign investor might not be heard at all or only in the nuance of a statistic.

Are there practical solutions?

It seems like a lot of bureaucratic tape needs to be cut here. But there is hope, particularly for foreign activist investors where having a voice is crucial to their strategy. If these investors want to be a “shareholder of record”, they need to proactively ask the Japanese sub-custodian or prime broker to be a direct standing proxy for them. This is outside the standard custodian service agreement and may cost extra, since the service is extremely time intensive. For example, before each record date, foreign investors will have to instruct share transfer from the normal custody account to the standing proxy’s account to be entitled to the right – all done manually.

There might be another solution. At a recent meeting Symphony moderated between Broadridge Financial Solutions and senior stock exchange representatives’ discussions centered around the implementation of a digital proxy voting system. Broadridge confirmed that they could solve many of these problems using the Investor Communications Japan (ICJ) technology backbone that ICJ has developed with Broadridge. One potential impediment however, is that the local Japanese bank owned Transfer Agents all use different systems for tracking share ownership. In any switch to a newer system, both the bank’s records would have to run in duplicate with the new ICJ system for some period of time risking confusion and extra costs. Even if the ultimate outcome was one where massive savings could be achieved by the banks, the current employees at the Transfer Agents would need to be repurposed. This is just one example of the hidden issues in the reality of shareholder equality and corporate governance in Japan.

One significant and common principle of the stewardship framework often found in other countries requires institutional investors to be responsible for proxy voting decisions and the proper exercise of shareholder rights. In particular, Japan’s recently introduced Stewardship Code is designed to empower shareholders to vote their shares, prodding management to act differently, shake up company boards, stimulate growth by improving profitability and capital efficiency, and ultimately increase total shareholder returns.

The sense of increased corporate accountability introduced by recent governance reforms in Japan under Abenomics is subverted by this flaw in foreign shareholder accountability due to the out-of-date proxy infrastructure, which has yet to catch up. If our collective hope is that introverted and conservative management may be improved by shareholder activism, a more simple and straightforward voting system is required. That could be the largest value-added service and lead to the achievement of the shareholder equality principle. Advances in fintech could pave the way for foreign owners of Japanese companies to seamlessly call on management for reforms. Until then, the current process may look acceptable on the surface, but it is a crucial disadvantage for investors, regardless of your domicile, and an impediment to the hope for accelerated economic growth in Japan.