Column 14 - Will the Introduction of Independent Directors Make the Japanese Stock Market Attractive to Foreign Investors?

NITTA Keisuke
Strategist, NLI Research Institute

Foreign investors are strongly demanding that Japanese companies be required to appoint a minimum number of outside directors who are truly independent from management (referred to below as "independent directors"). While such demands have been made for quite some time, they have intensified in recent years. The Asian Corporate Governance Association (ACGA), a non-profit organization supported by influential global institutional investors, released a white paper entitled " Corporate Governance in Japan "in May 2008 which explicitly calls for all Japanese companies to appoint a minimum of three independent directors.

Meanwhile, in Japan some influential government study groups - including one at the Ministry of Economy, Trade and Industry on corporate governance and another at the Financial Services Agency on the internationalization of Japan's financial and capital markets - have begun pondering the importance of adopting a system of outside directors to enhance management efficiency and attract foreign investors. It now appears that momentum is finally building to resolve some of the divisive issues that have kept investors and corporate managers at odds with each other.

Why do foreign investors attach so much importance to independent directors? First, there is a growing movement toward global convergence in corporate governance systems. Foreign investors lack confidence in the governance structure of Japanese companies because it deviates significantly from the standard model commonly used in other developed countries. Companies listed on major overseas stock exchanges, in contrast to typical Japanese companies, have more clearly defined mechanisms for management oversight and supervision, with those individuals occupying supervisory roles required to maintain a high level of independence from management.

Second, the Japanese-style board of directors, which is primarily composed of internally promoted directors, has been criticized for its lack of management transparency. Outside monitoring is thought to be necessary to improve the transparency of corporate management in Japan. For these reasons, foreign investors insist they are uncomfortable investing in Japanese companies.

If such a perception - or skepticism - of Japanese corporate governance is common among foreign investors and actually affects their investment decisions, it is likely that Japanese stock prices may be undervalued due to a "governance discount." At the same time, however, it is just as likely that the presence of independent directors has little to do with corporate business performance and growth potential. This view is quite reasonable because many academic empirical studies both in Japan and abroad have shown little correlation between the presence of outside directors and corporate performance. If so, the calls to adopt a system of independent directors may simply be a pretense and have no relevance for investment decision because investors basically are only concerned with investment performance.

Which one of these views is correct? If independent directors are an important factor in making investment decisions, foreign investors would show an inclination toward companies with independent directors. Such a tendency, if confirmed, would indicate that foreign investors are staying away from the overall Japanese market simply because the mechanism for monitoring management performance is considered weak.

I tested this observation using NEEDS-Cges (Nikkei Economic Electronic Databank System - Corporate Governance Evaluation System) data compiled from publicly filed financial statements, which include information on the presence (or absence) of outside directors - as defined by the Companies Act - as well as their degree of independence. Here, a company is considered to have a "highly independent" outside director if its board includes at least one outside director that has no record of having ever been employed by a (1) bank, (2) parent or controlling company or (3) subsidiary or affiliate, and is not serving as part of an exchange of directors between friendly companies, or serving concurrently as top management of another company. Alternatively, a company is considered to have a "marginally independent" outside director if one or more of the directors listed in its financial statements are outsiders, but none of them is considered "highly independent" based on the above criteria.

In the table below, companies listed in the first section of the Tokyo Stock Exchange are classified according to foreign ownership ratio and presence of outside directors. From this table we can see that the number of companies with outside directors has been increasing over the years, accounting for 45.26% of total firms in 2008. Furthermore, the fact that many companies place considerable importance on ensuring the independence of outside directors is also observable. According to the 2008 figures, of the 773 companies with outside directors 623 have at least one "highly independent" outside director.

Table: Presence of outside directors and foreign ownership ratio

Table:Presence of outside directors and foreign ownership ratio

Source: Compiled by NLI Research Institute based on data provided by the NEEDS-Cges database.

The table reveals distinct differences in the foreign ownership ratio of companies that do and do not have outside directors. In 2008, the average ratio of foreign ownership in companies with outside directors stood at 16.50%, or 3.85 percentage points higher than the 12.65% ratio among companies with no outside directors.

What is noteworthy here is that the foreign ownership ratio differs significantly depending on the degree of independence of outside directors. In 2008, the foreign ownership ratio for companies having "highly independent"outside directors" was 17.41%, a statistically significant difference of 4.75 percentage points higher than the ratio for companies with no outside directors. Meanwhile, the foreign ownership ratio for companies with "marginally independent" outside directors was 12.74%, which is not statistically different from companies with no outside directors.

These findings suggest the possibility that foreign investors' skepticism of Japanese corporate governance does indeed affect their investment behavior and as a result, that a governance discount exists in the Japanese stock market. But we need to remember that the above analysis does not provide enough information to confirm a causal relationship. That is, we cannot rule out the possibility that high foreign ownership induces companies to appoint independent directors, instead of that foreign investors seek out companies with independent directors. Alternatively, it may be the case that companies appoint an independent director due to a third factor that happens to also be correlated with foreign investors' preferences.

However, we must move forward on this issue because Japan cannot afford to postpone this decision until every reliable empirical finding has been pulled together and put on the table. The global economic crisis is forcing investors all over the world to tighten their purse strings, which reduces the amount of risk capital available for investing. Under these adverse conditions, Japan is confronted with the task of reinvigorating its stock market. One answer to this challenge lies in reassuring investors that a proper and well-functioning monitoring mechanism is in place for corporate management.

April 7, 2009

April 7, 2009

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