Increasing the presence of outside directors on the boards of Japanese companies is one of the most important reform issues in the area of corporate governance. The proportion of "independent outside directors" (i.e., "outside directors" defined under the Companies Act excluding those from banks and corporations with shareholding of 15% or more) out of all directors in 1,445 non-financial companies listed on the first section of the Tokyo Stock Exchange (TSE) has increased over the years to reach 9.6% as of the end of March 2011. The ratio, however, remains extremely low, considering that the proportion of independent outside directors is about 70% in the United States, 50% or higher in the United Kingdom, and greater than 30% in South Korea.
Against this backdrop, mandating the appointment of outside directors as one of the key amendments to the Companies Act is being proposed. In order to discuss the pros and cons of this proposal, accurately understanding the effects brought about by the composition of the boards of directors and the appointment of outside directors is essential. In this article, I would like to present some of the latest findings from my research with Ryo Ogawa of the Research Institute of Economy, Trade and Industry (RIETI) to provide some material for further discussion.
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First, those promoting the idea of mandating the appointment of outside directors contend that listed companies are continuously exposed to a potential conflict of interest, a situation in which corporate managers may not fully realize the interests of shareholders. According to their belief, directors appointed from outside differ greatly from those promoted internally in their knowledge and incentives for monitoring the management and hence are more likely to be able to increase the corporate value. They claim that the number of outside directors on the boards of Japanese companies remains small because top corporate managers—i.e., those who virtually have the authority to select and appoint directors—resent being monitored. For instance, Daio Paper Corporation, which drew significant public attention following the revelation of a major scandal involving the top management, had no outside directors.
Second, those skeptical of the monitoring function of outside directors say there is no need to mandate their appointment. They believe that having outside directors has no substantive effect because corporate managers can appoint ones who are loyal to them. For instance, in the case of Olympus Corporation's accounting scandal, there were three outside directors on the board at the time the company decided on problematic acquisitions as a way to conceal accounting losses. Apparently, they failed to play an effective monitoring role.
The third view is that mandating the appointment of outside directors does more harm than good. Those holding this view assert that each company selects the optimal composition of the board of directors according to the nature of its business, and appointing outside directors does not always lead to an increase in the corporate value. Indeed, Toyota Motor Corporation and Canon Inc. have chosen not to do so as they believe firm-specific knowledge based on the shop floor is indispensable to corporate decision making. Provided that all Japanese companies are acting in the same manner, their stance is that the decision to appoint outside directors should be left to each company.
Now, keeping these three views in mind, let's take a look at how the boards of directors of Japanese companies are composed.
We examined the boards of directors of Japanese companies listed on the first section of the TSE from 2005 through 2010 regarding the determinants and effects of their composition. We analyzed the determinants in terms of four factors, namely, the 1) complexity of the business requiring advice, 2) seriousness of the conflict of interest faced by the company, 3) degree of difficulty involved in acquiring information needed to monitor and offer advice, and 4) bargaining power of the management over shareholders. Variables used to measure each of these factors are as shown in the table with estimated results indicated by plus and minus signs. The plus sign (+) indicates that an increase in the corresponding variable leads to an increase in the number of outside directors, and the minus sign (-) indicates that the same leads to a decrease in the number of outside directors.
(Non-financial companies listed on the first section of the TSE)
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Typically, the composition of the boards of directors of Japanese companies is determined by the complexity of the business structure as seen in the diversity of business lines and the existence of a holding company structure, monitoring needs to prevent the abuse of anti-takeover measures, and the bargaining power of the management. Japanese companies are becoming more rational in choosing the structure of the boards of directors on the characteristics of their business operations, and this is, to some extent, consistent with the third view discussed above.
However, what should be noted is the fact that the proportion of outside directors tends to be higher for those companies in which the research and development (R&D)-to-sales ratio is higher and intangible assets play a greater role, whereby possessing special knowledge is critically important and accessing necessary information is difficult for outsiders. In theory, such companies should not have much need to appoint outside directors. Actually, evidence shows that an increase in the proportion of outside directors has either no or a negative impact on the return on assets (ROA) in a cohort of companies where information is difficult to access for outsiders. This finding suggests that their choices for the composition of the boards of directors may be biased.
Meanwhile, when focusing on the cohort of companies where information is easily accessible to outsiders, we can clearly see that an increase in the proportion of outside directors has a positive impact on the ROA. This finding is robust even when controlling for other potential factors affecting the ROA or when replacing the proportion of directors with the number of outside directors or the number of new appointments of such directors. That is, in the cohort of companies where information is easily accessible to outsiders, appointing outside directors remains rare despite the likelihood of their presence having a clear positive impact.
The ownership structure of Japanese companies has changed drastically in recent years from one dominated by banks and corporate shareholders toward one in which Japanese and foreign institutional investors together have a dominant presence. However, as the extent of such shift varies greatly from one company to another, we have taken into account differences across companies in their ownership structures.
Companies characterized by the significant presence of institutional investors as shareholders, namely, those belonging to the top 25% of the sample of companies in the institutional ownership ratio (threshold is over 34.4%), have high proportions of outside directors (11.5% on average). This cohort of companies, which are exposed to strong pressure from the capital markets, show a greater tendency to structure their boards of directors based on the characteristics of their business structures and in accordance with the abilities of the management. In particular, the composition of their boards of directors is likely to be determined by the complexity of the business and the need for monitoring the management. The probability of appointing outside directors increases when their business performance is worsened in relative terms, and decreases when top managers remain in their posts for a prolonged number of years.
In contrast, companies characterized by the insignificant presence of institutional investors, namely, those belonging to the bottom 25% in the institutional ownership ratio (threshold is under 11.2%), have low proportions of outside directors (6.6%). The composition of their boards of directors is not much affected by such factors as the complexity of business and the need for monitoring the management. No clear correlation is observed between business performance and the appointment of outside directors, while the latter is slow to happen when top managers hold significant ownership stakes. In this context, it is highly plausible that the proportion of outside directors in those companies not exposed to significant pressure from the capital markets remains lower than expected. So long as this cohort of companies is concerned, the view held by those focusing on the personal interests of corporate managers and hence calling for mandating the appointment of outside directors certainly holds true.
The empirical findings discussed above strongly point to the need for measures to promote the appointment of outside directors. Many of the companies where information is perceived to be easily accessible to outsiders given the nature of their business—particularly those not exposed to significant pressure from the capital markets—have no outside directors, despite the high likelihood of their appointment resulting in greater corporate value, as top managers prioritize their personal interests over that of their companies. In the case of such companies, simply leaving things to the markets would not improve the situation, and it is absolutely necessary to implement some sort of measures to promote the appointment of outside directors.
Takuji Saito, associate professor at Keio University, and Konari Uchida, associate professor at Kyushu University, have obtained similar conclusions. Thus, it is safe to say that all empirical analysis findings are in support of the calls for mechanisms or measures to promote the appointment of outside directors.
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At the same time, however, our other important empirical findings are that the structure of Japanese companies' boards of directors in recent years is to some extent in accordance with the characteristics of their business and that the effects of appointing outside directors vary significantly depending on the nature of the companies. This implies that mandating all companies to appoint outside directors not only has benefits but also costs. Particularly, for those companies where information is not easily accessible to outsiders, such mandatory system is highly likely to have a negative impact on corporate value. Thus, in terms of institutional design, it is desirable to leave companies room to make their own choices, rather than requiring all companies to appoint outside directors.
In view of the Interim Proposal concerning Revision of Companies Act, it is hoped that the relevant government council will promote a system allowing companies to choose a corporate structure with an audit and supervisory committee, while continuing to make careful consideration of the proposal concerning the mandatory appointment of outside directors. Provided that the purpose of reform is to protect the interests of minority shareholders of listed companies, the British approach known as "comply or explain" is worthy to be considered as a supplementary measure, whereby appointing outside directors would be defined as a desirable system—i.e., the default setting—in the TSE securities listing regulations, and companies would be held accountable for opting out.
In addition, as proposed by some market participants, public pensions may set forth certain provisions regarding outside directors as part of the investment selection criteria for outsourced fund managers to follow. Requiring fund managers to limit equity investment only to those companies that have at least one outside director would have almost the same effects as those of other measures.
* Translated by RIETI.
June 25, 2012 Nihon Keizai Shimbun
