The 2006 Asian Roundtable on Corporate Governance Session 2 Enforcement Problem in Japan Seki Obata Keio Business School Japan Bangkok, Thailand September 2006

Japan could be the best capital market Japan: –Very well developed Economy –The Second largest capital market –Quality of Government ： very high –Rule of law: good quality Japanese Financial Market could be the ideal one without corporate governance problems

What factors important? For capital market development –Good economy –High level income per capita –Good quality of government Most important one: Legal system

Law is important Legal system is one of the most important factor for financial market –Outside Investor protection Is the key factor –Shleifer et al (1997,1998 ） Legal origin seems matter –Common law countries' markets perform better

Why does legal system matter? Protection on outside dispersed investors –By statues (Shleifer et al 1997,1998) –Common law countries protect outside investors, French law countries do not. –German law countries protect them moderately well. Japan: –Score of investor protection is high –but not so much as Singapore and HK

Still, Japan has the governance problem Why? Japanese problems are not so wild –Not direct theft of corporate cash flow or assets –Financial figure manipulation –Insider trading –Unfair transaction in the stock market

Bad enforcement Japanese law: the statute is very good But Enforcement system is not effective. Law efficiency score: much lower compared to the score for the statute

Why bad enforcement? Corruption? –Not the issue in Japan Incentive? –Not strong incentive to wipe out insider trading and price manipulation for government official –but not so weak Shortage of staffs –Now improving

Two fundamental problems Legal structure –German law system –But commerce law and security law: imported from US after the WWII –Mismatch –Ex: security law stipulate that all unfair transaction and insider trading prohibited and punished –Practically, prosecutors and court both seem hesitated to use this code: unbalanced with all other legal systems and legal convention –Emphasize the bright line rule, not discussion in the court room

High Legal cost Rare private enforcement –Legal cost is very high –Not only financially but culturally –Then shortage of lawyers in this field and also their experience –The same story for judges

Encourage the gamble Therefore, only clearly illegal transactions would be indicted Prosecutors need the bright lined crime Then, those who focus only on the cash return (not reputation) would try to execute the risky transaction in the gray zone Gray zone: substantially illegal but no violation of the bright line rule Only bad people try to gamble and they would be never captured if they are clever and sophisticated enough Bad people would thrive and decent people feel unfair.

High legal cost also for public enforcement Incentive for prosecutors –They should win a case with 100% probability –This comes just from convention: People believe that prosecutors’ decisions are always right

Livedoor case –CEO and founder Horie and other directors arrested and indicted now on trial –Effectively insider trading and unfair transaction (price manipulation) –However, prosecutors tries to establish this case as manipulation of accounting figure and intentionally false disclosure –Because of the bright line rule sentiment

Murakami case Activist fund manager Murakami also arrested related to Nippon Broadcasting System that Livedoor tried to buy out Insider trading Livedoor directors told prosecutors facts of insider trading Prosecutors finally decided to arrest Murakami This time, prosecutors got the evidence of confession from Livedoor directors

Other factors Cultural factors –Not strict opinion on insider trading –Investment on some stock usually some kind of insider information

Other factors II Private enforcement: not effective in Japan One reason: no large shareholder with an incentive to maximize the share price Good corporate governance system without the player to implement