Reform of the Board of Directors and Diversification of Corporate Governance

ARIKAWA Yasuhiro
Faculty Fellow, RIETI

The Legislative Council submitted revisions to the commercial code centered on things such as the introduction of an Anglo-Saxon style system for corporate directors that among other things, has various committees and directors from outside the company. Since this revision proposal also provides for the option to select a traditional board of directors' system, active discussions are being carried out surrounding the efficiency of more independent outside directors. Using the results from empirical research concerning the role of board of directors in the United States, the purpose of this paper is to examine the question of what the impact of current reforms will have in reforming corporate governance in Japanese firms. In particular, I would like to discuss how changes to corporate governance could be a measure for improving performance.

Outside Directors and Corporate Performance

Reforms to the system of board of directors including the compulsory introduction of outside directors are believed to improve corporate performance through management with closer attention to shareholder's value. However, can this really be true? Is it not possible that information restrictions render the existence of outside directors useless for improving corporate performance? Using U.S. and U.K. firms as a sample, there are already volumes of empirical research on the relationship between the proportion of independent outside directors and corporate performance. However, results are varied and do not offer a clear cut answer overall as to whether independence in the board of directors leads to improvements in corporate performance. For example, in comparing companies where the highly independent directors occupy a larger number of the boards to companies without such boards, there is scant evidence to indicate that the former produces better performance. With this in mind, what about CEO replacement? In the highly independent boards of directors, when corporate performance wanes, a mechanism to quickly replace the CEO is expected to be in place. Regarding this point, there is the conclusion that having the majority of independent directors will lead to a faster replacement of incompetent managers. However, so long as corporate performance does not significantly deteriorate, the independent directors will not move to reshuffle management, and so this function seems quite limited. Rather, the pressure of takeovers from capital markets plays a larger role in replacing managers. Judging by the results of empirical studies, even in the U.S. there are many unclear points whether a more independent board of directors improve corporate performance, and the mechanism to immediately replace incompetent management is not as effective as expected.

Incentives for Directors

What needs to be done to make independent outside directors function properly? The most important point is that incentives be provided for the directors. Looking at numerous tests in the U.S. and Europe, it is irrelevant whether the director came from inside or outside the company, but there is a definite positive correlation between the directors' equity shareholdings in the company and that company's performance. This suggests that outside of boards of directors, monetary incentives such as a compensation based upon corporate performance are important for corporate governance. Hosei University Professor Xu Peng pointed out that incentives of outside directors to monitor management teams voluntarily for the interests of shareholders are not particularly strong. Accordingly, it is thought to be necessary to put the directors' interests in line with shareholder interests through use of monetary incentives like stock options for directors and thereby provide an incentive for monitoring, irrespective of whether they are from inside or outside of the company.

The Importance of Market Competition

As a method of maintaining corporate efficiency, the role of competition in product markets must not be forgotten. If poorly performing companies are weeded out through strict market competition from the start, there is no need to pin one's hopes on a monitoring system based on legislation. In actuality, there is research to suggest the existence of a substitutive relationship between the governance from shareholders and the governance from market competition. With this in mind, companies where monitoring by the board of directors and/or the shareholders carries great significance, are those that do not directly confront harsh competition in the market; or specifically, those companies that are afforded regulatory protection and those companies that do not directly confront international competition. Conversely, in the case of companies that are exposed to severe competition in the market, odds are low that the structure of the board of directors will have a major impact on corporate performance.


As has been clearly shown from the research on U.S. firms, which have served as the model for legal revisions, the efficiency of independent outside directors is not self-evident. On the contrary, there are several other methods of corporate governance. .Boards of directors, compensation based on corporate performance, discipline through shareholders and competition in product markets - how well each factor functions will vary from company to company, and no single one will always fulfill a decisive role. At this time it is unclear how corporate governance will change with the revisions to the commercial code, but there is a high probability that diverse systems will co-exist rather than to simply be converged into one system which mainly depends upon monitoring by independent boards of directors. What is important is to consider a system that allows companies to freely experiment with various methods for corporate governance, while at the same time quickly allowing companies that have failed in its choices to exit from the market.

March 26, 2002

March 26, 2002

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