The reform of boards of directors has been one of the central issues in discussions on Japanese corporate governance. Streamlined boards and the introduction of the executive officer system attracted a fair amount of attention in the late 1990s, followed by some high-profile appointments of outside directors, and later the legislation of a company-with-committees system as the trend progressed in more recent years.
At present, however, there seems to be no general consensus among practitioners and scholars on the fundamental question: What is the optimal structure and role of a board of directors? In this column, I attempt to provide a new perspective on this question through recent research findings and consider some of the future challenges facing boards of directors by focusing on their authority and independence.
The board of directors and corporate performance
For corporate governance researchers, an important starting point that has also been one of the difficulties in analyzing boards is the fact that the potential impact of board characteristics (such as the overall number of directors, ratio of outside directors, and independence) on corporate performance has not been clearly observed in empirical studies. In other words, prescriptions for the ideal board composition cannot be derived from actual data alone.
One of the reasons why empirical studies have failed to identify an optimal board structure can be explained in part by the relationship between the introduction of outside directors and corporate performance. In recent years it has been well publicized in newspapers and business magazines that companies with more outside directors should perform better, based on the naive presumption that outside directors monitor management more effectively than insiders. However, numerous empirical studies have been unable to support this simple hypothesis. The fact that high performance companies are generally unwilling to adopt outside directors can be cited as one of the major factors for this phenomenon. This outcome may seem quite natural. But if a company that does not adopt outside directors has better performance, this brings up the very basic question of whether outside directors actually have a positive effect on corporate performance.
The function and independence of the board of directors
Following these empirical results, recent theoretical studies have come to take a more realistic look at the role of the board and the directors who constitute it. The board's specific functions have been a common focal point in these studies.
In its legislative role, a board primarily makes important policy decisions, supervises management, and appoints and dismisses the chief executive officer (CEO). In Japan it is often heavily involved in operational decision making too. However, even taking for example fairly obvious duties such as decision making and management supervision, the expected roles and desirable degree of independence of a board vary a great deal, depending on whether it actively makes decisions or simply gives advice to the CEO, who is the ultimate decision maker.
The board as decision maker or adviser
For the sake of argument, let's assume that outside directors have the power and authority to reverse decisions made by the CEO. In such a case, a high level of independence from the CEO is of paramount importance. If outside directors and the CEO share common interests, the "authority" of outside directors becomes meaningless because they will align themselves with the CEO and simply rubberstamp his decisions.
Independent outside directors with sufficiently strong authority precisely embody the legislative role in areas such as decision making and management supervision. However, in order to correctly evaluate the decisions of management and especially those of the CEO, directors may need to be very familiar with the actual conditions of the company. They would also have to have considerable business experience and managerial expertise. It may well be extremely difficult, in reality, to find outsiders with these attributes who are willing and able to represent shareholders' interests independently from management.
If the decision making and management supervision provided by outside directors comes in the form of advice imparted to the CEO, the final decision maker is still the CEO, but the outside directors now supply the CEO with new management information and a critical assessment of his proposed decision. It appears that this role is considered to be appropriate for outside directors in many Japanese companies, which brings up yet another important question: How much emphasis should be placed on the independence of outside directors when they play primarily an advisory role?
Interestingly, theoretical studies show that outside directors as advisers need not maintain completely independent interests from the CEO. Contrary to the case of outside directors who are expected to influence managerial decisions directly, it is more desirable for these advisory directors to have a close relationship, to a certain degree, with the CEO. This is important because a CEO who makes final decisions can at any time ignore advice from outside directors with sharply conflicting interests, and therefore may not listen to them from the very beginning. In other words, the effect of the "independent adviser" is likely to be small if his interests are completely independent from those of the CEO.
Meanwhile, if the independence of outside directors as advisers is low, advice will not always benefit shareholders even though it may be useful to the CEO. Therefore, the effectiveness of those outside directors with respect to corporate performance can be severely limited
Although these theoretical considerations have been extremely simplified and lack many realistic elements, they still clearly illustrate that the importance of outside directors and their level of independence are questions not easily answered. The observation that desirable attributes of directors vary significantly depending on their specific roles deserves more serious attention, not least because it seems neglected much too often in discussions by practitioners and policymakers.
Allocation of authority between shareholders and the board of directors
Finally, I would like to mention reform of the board of directors and shareholder power. In Japan, despite appearing extremely weak on the surface, the legislative powers granted to shareholders are in fact fairly strong compared to those in the U.S. For example, while the right to decide on dividends lies with the board of directors in the U.S., in Japan it rests in the hands of the shareholders and must be approved at the general shareholders' meeting. Shareholders' proposal and convocation rights in the general meeting are more widely accepted in Japan.
Suppose hypothetically that Japanese firms are required to have a highly independent board of directors. What would then be the power relationship between shareholders and boards dominated by outsiders whose main duty is to make policy decisions and monitor management? The current Japanese legislative system that gives greater powers to the general meeting of shareholders could pose conflicts with the performance of duties by U.S.-type boards. For example, if decisions made by the board can be easily reversed at the general meeting of shareholders, the board may become more apt to relax its efforts toward making appropriate decisions in the first place.
Interestingly, Japanese companies that have been promoting U.S.-style boards also tend to have less cross shareholdings and greater representation by foreign shareholders, some of whom are regarded as "activist" shareholders. Therefore, for those companies the direct exercise of shareholder control, which is in principle far more difficult in the U.S. than in Japan, has become increasingly more realistic. The legislative and "real" allocation of authority between the general meeting of shareholders and the board of directors has yet to be examined in either theory or practice, and it remains a particularly noteworthy topic for the future.
