This PDF is a selection from a published volume from the National Bureau of Economic Research Volume Title: A History of Corporate Governance around the World: Family Business Groups to Professional Managers Volume Author/Editor: Randall K. Morck, editor Volume Publisher: University of Chicago Press Volume ISBN: 0-226-53680-7 Volume URL: http://www.nber.org/books/morc05-1 Conference Date: June 21-22, 2003 Publication Date: November 2005 Title: A Frog in a Well Knows Nothing of the Ocean: A History of Corporate Ownership in Japan Author: Randall Morck, Masao Nakamura URL: http://www.nber.org/chapters/c10274 7 A Frog in a Well Knows Nothing of the Ocean A History of Corporate Ownership in Japan Randall K. Morck and Masao Nakamura 7.1 Introduction An ancient Japanese proverb speaks of a frog prideful of the beauty at the bottom of his well and ignorant of the world beyond. The history of Japanese corporate governance is especially interesting because the Japan- ese literally searched the world for the best institutions of capitalism, and changed their institutions more radically and more often than in any other major industrial economy. These changes, and the associated successes and failures associated, illuminate fundamental issues of corporate gover- nance, corporate control, and the economics of institutions. Historical and contemporary research into corporate ownership in Japan both focus on intercorporate networks. In the last third of the twen- tieth century, the interfirm networks of interest are horizontal and vertical keiretsu groups. Horizontal keiretsu, like the Mitsui group, are interindus- Randall K. Morck is the Stephen A. Jarislowsky Distinguished Professor of Finance in the School of Business, University of Alberta, and a research associate of the National Bureau of Economic Research (NBER). Masao Nakamura is Konwakai Japan Research Chair and pro- fessor at the Sauder School of Business and the Institute of Asian Research, University of British Columbia. We are grateful for comments by Sheldon Garon, Akiyoshi Horiuchi, Yishay Yafeh, and two anonymous reviewers on an earlier version of this paper, entitled “Been There, Done That: The History of Corporate Ownership in Japan.” We are also indebted for useful sug- gestions to Barry Eichengreen, Masaharu Hanazaki, Katsuyuki Kubo, Richard Sylla, Seki Obata, Dwight Perkins, Juro Teranishi, Yupana Wiwattakantang, and participants in the NBER History of Corporate Ownership conference. The Rise and Fall of Great Business Families at Lake Louise in 2003, the European Corporate Governance Network (ECGN)– NBER–University of Alberta–INSEAD conference of the same name at Fontainebleau in 2004, the Strategy and Business Economics seminar at the University of British Columbia, and the Hitotsubashi University Workshop on Corporate Governance in East Asia. This re- search was done while Randall K. Morck was visiting Hitotsubashi University in Tokyo. 367 368 Randall K. Morck and Masao Nakamura try networks of firms whose small individual equity stakes in each other collectively sum to control blocks. Vertical keiretsu encompass the suppli- ers and customers of a single large firm, such as Toyota Motors. In both variants, public shareholders only have access to minority interests, ren- dering them essentially irrelevant to corporate governance. Adjunct to the keiretsu networks, most Japanese firms have strong ties to their lead lenders, or main banks. However, keiretsu are a relatively recent development. During the feudal Takagawa period (1603–1868), Japanese firms were owned entirely by fam- ilies—or, perhaps more properly, by clans. The Mitsui and Sumitomo fam- ily businesses both emerged during this era. In both cases, extensive sets of family rules and traditions determined corporate governance issues. Following the Meiji Restoration of 1868, the new government promoted rapid industrialization. The Mitsuis, Sumitomos, and other new family businesses like Mitsubishi (run by the Iwasakis) needed capital vastly in excess of their own wealth, and they turned to public equity markets. The families organized a new firm to float equity for each new venture and or- ganized them into pyramidal groups. At the apex of each was a family partnership (later a family corporation), which controlled several public corporations, each of which controlled other public corporations, each of which controlled yet other public companies, and so on. These structures, called zaibatsu, resembled modern Korean chaebol and similar pyramidal groups elsewhere.1 Despite much research, the contributions of zaibatsu to the rapid development of the prewar period remain unclear. The zaibatsu were clearly key players in this development. But questions remain about whether powerful zaibatsu families grew overly concerned about preserving their wealth and control, and avoided high-risk projects in new industries that might have further accelerated Japan’s modernization. Also, zaibatsu- controlled banks that lent solely to other firms in their zaibatsu failed dur- ing the interwar depressions, exposing problems inherent in related lending. During World War II, Japan de facto nationalized many major corpora- tions, subordinating them to central planners.2 The Temporary Funds Ad- justments of Law of 1937 created the Kikakuin, or Planning Agency, to centralize economic planning and administration. This required corporate boards to obtain government approval for most important decisions, such 1. The Kanji characters for zaibatsu are pronounced chaebol in Korean. One sees a stricter adherence to blood kinship in the governance of chaebol. Confucianism, influential in Korean cultures, extols respect for family, while Japanese Buddhism allows more leeway for sidelin- ing inept blood kin. 2. Central planning in Japan involved rigid central plans, state command and control over all aspects of the economy, and the de facto abolition of ownership rights for capital. How- ever, de jure private ownership of land was retained, as in communist Poland, as was de jure private ownership of zaibatsu and many other private-sector corporations. Japanese central planning was corporatist, rather than socialist, though much rhetoric of the period obscures this. A Frog in a Well Knows Nothing of the Ocean 369 as changing their articles of incorporation and issuing equity or debt. Fur- ther government decrees abolished boards’ rights to set dividends in 1939 and to appoint managers in 1943, reassigning these powers to Kikakuin. Although established by an extreme right-wing government, the Kikakuin consciously imitated many of the planning methods the Soviet Union used for its heavy industrialization in the 1930s.3 As in Nazi Germany, this was accomplished amid much condemnation of “shareholders” (meaning the controlling shareholders, or zaibatsu families) for their self-interest, risk aversion, and unpatriotic myopia. This rhetoric would resurface later as a jus- tification for depriving small shareholders, rather than controlling share- holders, of governance input. Following the war, Japan was governed by the United States military from 1945 to 1952. General MacArthur broke up the zaibatsu. Conse- quently, Japan was briefly a widely held economy, like the United States and United Kingdom, in which most large public companies had no con- trolling shareholders. Japanese firms undertook hostile takeovers of each other, and raiders extracted greenmail from unwilling target firms. Following the end of the U.S. occupation in 1952, Japanese firms began preempting takeovers by acquiring white squire positions in each other.4 The major banks were often key in organizing these intercorporate equity place- ments. These holdings grew into the keiretsu system in the 1950s and de- veloped more fully in the 1960s. That system, which still characterizes Japa- nese big business, is now under growing stress. At the beginning of the current century, Japan is once again bracing for major institutional changes. Throughout all of these changes, the principals of Japan’s great busi- nesses actively pursued their own interests, balancing profit and control. In general, they shaped and reshaped organizational forms to accommodate this balance as new legal and other constraints emerged. This paper exam- ines the emergence and evolution of these different organizational struc- tures as responses to changing political and institutional circumstances. Of course, institutional changes also reflected lobbying by big business. However, critical points in Japan’s business history seem to involve exoge- nous events that clearly required adaptation by the business sector. The abrupt opening of Japan to world trade and the decision of the Meiji gov- ernment to embark on a crash program of modernization are examples. The generally negative attitudes of both the Japanese military government and the Allied occupation force in the mid-twentieth century to the great zaibatsu families are two others. Many factors underlie the rise of zaibatsu and the organization of keiretsu—economies of scope and scale, reputation, the circumvention of 3. See Okazaki (1994) for details. 4. A white squire is a friendly firm that buys a block of stock in a target firm to protect it from a raider. If the friendly firm takes the target over entirely, it is called a white knight. 370 Randall K. Morck and Masao Nakamura flawed markets and institutions, and numerous other factors. However, we argue that the primary purpose of both zaibatsu and keiretsu was to protect the control rights of the great zaibatsu families