Board reforms were at the center of the corporate governance reforms under Abenomics, The pillars of this board reform are the Corporate Governance Code and the Stewardship Code (principles for responsible investors). This column will examine what progress has been made in board reforms in Japan, what effects have resulted through the introduction of the governance code and what problems remain.
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The Corporate Governance Code which went into effect in June 2015 required, in principle, the election of two outside directors to each corporate board, or an explanation, in the event that they were not elected. As a result, whereas in 2013, 69% of companies listed on the first section of the TSE had one or fewer outside directors, in July 2018, the amount of companies that had elected two or more outside directors reached 95%. Among the companies comprising the "JPX NIKKEI 400" stock index, the number of outside directors increased to more than three for every company, and even among the other relatively small companies, the appointment of outside directors increased dramatically (See table).
Did this increase in the number of outside directors actually lead to improved management? The policy-makers assumed the existence of a group of companies with a need for increased numbers of outside directors, and that the adoption of the code would encourage the companies to appoint outside directors, which, in turn, would change management policies and improve operating outcomes.
However, there is also another possible scenario: Japanese companies already had appropriate levels of outside directors, meaning that companies that did not need outside directors would be encouraged to appoint outside directors to no effect. There was also the possibility that the increase in the number of outside directors would only be a nominal amount, with little effect. In both of these negative cases, management policies would not be impacted and there would be no change in corporate performance.
In order to examine which of these scenarios was correct, the authors, by using the adoption of the Corporate Governance Code, attempted to estimate the causal effect of the increase in outside directors on corporate performance and corporate behavior. According to the empirical results, the increase in outside directors, on average, did not improve performance, and, at first glance, the latter scenario seems to have been valid.
However, when corporate attributes were taken into consideration, it became evident that companies with lower percentages of foreign investor shareholders and that were less susceptible to the market discipline experienced greater improvement effects in performance as a result of increases in outside directors. For example, a 10 percentage point decrease in the ratio of foreign shareholders resulted in a 0.6 percentage point rise in the improvement effect on ROA when the number of outside directors increased by two.
Additionally, the results also demonstrated that the increase in the number of outside directors was effective in family-controlled companies. A 10 percentage point rise in the shareholding ratio of board members resulted in a 0.3 percentage point rise in the improvement effect on ROA when the number of outside directors increased by two.
Moreover, in terms of size (of sales), the effects of the increase in the number of outside directors were most evident in medium-sized companies. This suggests that the effects of the increase on large companies were small due to the fact that corporate governance had already been established at these companies, and conversely, at small companies, the cost of appointing outside directors may have offset the benefits.
However, in terms of the promotion of risk-taking, which had been anticipated by Abenomics, the increase in the number of outside directors had no effect on increasing investments or R&D expenditures, whether the results were viewed as averages or whether corporate attributes were considered. On the contrary, the increase in the number of outside directors may have had the effect of reducing investments and may have encouraged the review of businesses and organizational reform.
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The corporate governance reforms provided an opportunity for companies to improve the organization of their boards of directors. The Companies Act, which was revised at the same time as the enactment of the Corporate Governance Code, offered companies the choice of incorporating a new type of board structure, (i.e. a company with audit and supervisory committees) in addition to the conventional type of company with a board of corporate auditors; and a type of company common in the US (companies with nominating committees). The supplementary principles of the Corporate Governance Code also recommended the establishment of voluntary committees such as nominating and compensation committees.
The effects of these reforms were immense. As shown in the table, while only a small percentage of companies have chosen to become companies with nominating committees, 24% of the companies have chosen the structure with audit and supervisory committees. There has also been a significant increase in the number of companies establishing voluntary committees, and among the JPX400 companies the percentage has exceeded 50%. In the other group, only a few voluntary committees have been established, despite the proactive use of audit and supervisory committees.
The transition to an audit and supervisory committee structure has had no clear effect on corporate behavior or performance for the time being. This suggests that the transition to an audit and supervisory committee structure was chosen more as a way of addressing the shortage of outside directors than as a way of merely improving corporate governance.
Meanwhile, voluntary committees have had practical effects. According to the authors' estimates, where ROA changed by 5 percentage points, the change in executive compensation was 9 percentage points greater in companies with voluntary compensation committees than in companies without voluntary compensation committees. This suggests that the establishment of voluntary compensation committees has raised the proportion of performance-based compensation to overall executive compensation. Furthermore, nominating committees have been raising sensitivity of top executive turnover to company performance. Where ROA declined 5 percentage points from the average, the rate of management being replaced among companies with nominating committees rose by 1.3 percentage points compared to companies without such committees.
The establishment of voluntary committees could potentially impact corporate behavior and performance by elevating the incentives of management and enhancing the quality of decision-making of the board. According to one estimate used to analyze this relationship, while the improvement effect of the establishment of voluntary committees on performance is not sufficiently clear, establishing the committees seems to have significantly impacted corporate financial policies. Increases in payout ratio and decreases in cash holdings have been confirmed at companies that have established voluntary committees.
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Thanks to corporate governance reforms, the appointment of outside directors, which had previously been incremental at best, has been progressing at a rapid pace. The appointment of two outside directors has become standard, and it is now up to the companies to make effective use of these reforms. One way to enhance effectiveness is to establish voluntary committees. Nissan Motor's failure to establish a compensation committee, which inevitably led to the ambiguities surrounding Chairman Carolos Ghosn's remunerations, is still fresh in our minds.
However, there is the problem of whether two outside directors would be enough to steer multiple committees, if committees were to be established to appoint top executives, formulate succession plans, evaluate management results and execute other tasks. Going forward, as further improvements are made to the corporate structure, companies will probably be called on to consider an appropriate number of outside directors not limited to the two as prescribed in the Corporate Governance Code.
Personnel selection of the outside directors is another significant matter. At this time the problem of the lack of diversity has not been resolved. According to a survey by METI (as of January 2018), the percentage of companies with at least one female director was 29%, and the percentage of companies with a foreign national as director was merely 5%. For companies that are intent on global business development, this matter calls for urgent attention. Independence criteria is also a matter that needs to be considered. The question of whether it is acceptable to consider an executive dispatched from the parent company as an independent director at listed subsidiaries requires particular attention.
Another serious problem is the increase in directors serving concurrently due to the shortage of outside directors. In the aforementioned survey, 41% of the companies have elected outside directors that serve concurrently at other companies, and the percentage seems to be rising. In a study conducted on companies in the United States, in companies with outside directors serving concurrently at three or more companies making up the majority of directors, the profitability and the sensitivity of CEO turnover to performance was lower. Many companies demand management experience from outside directors, but such human resources are rare. An important goal will be to resolve the conflict between securing persons with management experience and avoiding directors serving concurrently at other companies.
* Translated by RIETI.
January 21, 2019 Nihon Keizai Shimbun
