This month's featured article
Why Outside Directors in Japan are Not Prevalent?
SAITO TakujiAssociate Professor, Faculty of Economics, Kyoto Sangyo University
Corporate boards of directors in Japan have undergone significant changes in recent years. Traditionally, the boards of directors of most listed companies in Japan have been composed solely of insiders, with the number of board members tending to be large by international standards. However, from around the mid 1990s, Japanese companies came under fire for such boards with critics claiming that, "boards comprised solely of inside directors, are unable to fulfill their role of overseeing management" and that "the presence of too many directors inhibits dialogue." Taking these comments on board, Sony Corp. introduced the executive officer system in 1997, which significantly reduced the size of their board, and many companies then followed suit. Meanwhile, the 2001 amendments to the Commercial Code, which limited the responsibilities of outside directors, resulted in an increase in the number of companies appointing outside directors. However, despite the law change that effectively worked to reduce the burden on outside directors, and despite mounting demand from shareholders including investment funds, the appointment of outside directors has not become as common a practice as expected. Even now, approximately half of the listed companies in Japan do not have outside directors, and their boards are composed solely of internally appointed directors. A proposal to mandate the appointment of a certain number of outside directors has been discussed from time to time but has yet to be adopted as a government policy due to strong opposition from the business community. In what follows, I will examine the characteristics of companies that have appointed at least one outside director and based on the changes that have resulted from such an appointment, look into the reasons why this practice has not become commonplace in Japan.
What is the role of an outside director?
To begin with, what kind of role is an outside director expected to play?
In large-scale listed companies in which ownership and management are clearly separated, there is the issue of conflict of interest between management and shareholders. Therefore, when entrusted with management responsibilities, managers may act to maximize their own interests even at the expense of shareholders' interests. The wasteful use of resources, symbolized by an excessively luxurious office building and a corporate jet, is an obvious example but there are many less obvious cases such as underinvestment and overinvestment. A board of directors is required to oversee corporate managers and prevent them from acting against shareholders' interests. However, it is virtually impossible to fulfill this role when the board of directors is dominated by inside directors. Most inside directors are themselves engaged in management, for instance, as division head and it is often the case that the chief executive officer is their supervisor. Therefore, it is hard to expect inside directors to act as guardians of shareholders' interests and where outside directors are counted on to come into play as management watchdogs.
Outside directors' principal employment is external to the company for which they serve as an outside director and they are financially independent from the company's management. Therefore, it is perceived that outside directors can act more in line with the interests of shareholders, compared to inside directors. In other words, outside directors are expected to play the role of monitoring management and ensuring that managers run the company in a way that serves the wishes of shareholders rather than their own.
What kinds of companies have outside directors?
Now, what kinds of companies have appointed outside directors in recent years?
Using a sample of 483 companies that have been at least temporarily included on the Nikkei 500 during the period from 1996 to 2006, I conducted an empirical analysis to determine what factors affected the probability of having at least one outside director. Financial institutions and companies that are a subsidiary or affiliate of another company have been excluded from the sample.
The primary finding of the analysis was that companies are more likely to appoint an outside director when: 1) they invest heavily in R&D, 2) their share price is highly volatile, and 3) they have low free cash flows.
Companies with large R&D investments are presumed to be engaged in business that is highly specialized and difficult for industry outsiders to understand, as is the case with pharmaceutical companies. It is thus perceived to be difficult for outside directors to effectively monitor the management of these companies. Meanwhile, the high volatility of a company's share price indicates that, in the eyes of investors, a high degree of uncertainty surrounds the company's business. It is again difficult for outside directors to effectively monitor the management of such companies.
Having low free cash flows is to have little money available for use in business. It is presumed that corporate managers have little chance to squander management resources.
In a nutshell, Japanese companies that have appointed at least one outside director tend to have either one or both of the following characteristics: 1) it is difficult for outside directors to effectively monitor management, and 2) there is little chance for managers to squander management resources. This finding is quite shocking.
Reversely, it means that the kinds of companies in which the presence of outside directors would make a big difference - i.e., those that are relatively easy to monitor from outside and/or pose a relatively high risk of managers wasting resources - have chosen not to appoint any outside director. These findings are opposite to those of preceding studies on the composition of the boards of directors of American companies, which is widely perceived as being structured in a way to allow effective monitoring by shareholders. Some such studies in the United States empirically showed that companies with small R&D investments, low share price volatility, and large free cash flows tend to have many outside directors.
What impact do outside directors have on business performance?
What changes have been observed in the business performance of companies that moved to appoint an outside director? To find an answer to this question, I examined 144 companies that appointed their first outside director in recent years, based on the same survey sample as above. Specifically, I measured the reactions of the stock market to media reports on the appointment of an outside director or directors and the changes in these companies' profit margins following the appointment. The reactions of the stock market were measured by cumulative abnormal returns (CAR), a measure frequently used in analyzing corporate finance. The stock prices of these companies responded in a statistically significant manner, rising by about 1.2% on average and about 1% at the median. This indicates that investors take the appointment of an outside director or directors in a favorable light.
To measure the impact of outside directors on profit margins, I created a control group consisting of companies that have matching characteristics but have not appointed any outside directors, and then, compared changes in the profits margins observed in the companies having at least one outside director to those observed in companies in the control group. As a result, it was found that profit margins improved in a statistically significant manner for companies that have appointed at least one outside director, compared to their counterparts without outside directors.
These findings can be interpreted as indicating that the appointment of outside directors is effective as a means to enhance the performance of companies both in terms of stock prices and profit margins.
Now, based on these analysis results, I would like to return to the question of why only a small number of Japanese companies have adopted a board system with outside directors. As discussed above, the probability of the appointment of such a director is low for companies that are easy to monitor from outside and/or where the potential for managers to waste resources is high, despite the finding that the presence of outside directors has a positive impact on business performance.
This implies that the lack of a positive effect is not necessarily the reason why the appointment of outside directors has not become a common practice in Japan. Rather, it points to the possibility that managers - particularly those who would become subject to rigorous monitoring and thus lose their freedom in management - might have been resisting the appointment of outside directors. For corporate managers, any mechanism imposing discipline on them, including but not limited to outside directors, is not something they welcome. In reality, however, the decision regarding whether or not to introduce such governing mechanisms is left to corporate managers. This is the reason why outside directors and some other governing mechanisms fail to be introduced despite their obvious benefits.
This also explains why in the U.S. and some other countries, companies are required by law to appoint a certain number of outside directors. Thus, Japan may as well consider following suit, making it mandatory for companies to have a certain number of outside directors, which is indeed one good way to improve corporate governance. However, it should be remembered that the introduction of such mandatory rules could cause an additional burden on - and even undermine the efficiency of- companies that already have efficient governance mechanisms in place. It is thus necessary to conduct further scrupulous research to decide whether the mandatory appointment of outside directors is the optimum choice for Japan.
The original column was published in Japanese on August 31, 2009.
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