This month's featured article
Outside Directors and Productivity
MORIKAWA MasayukiVice Chairman & Vice President
Corporate scandals and corporate governance
A series of corporate scandals including those involving Daio Paper Corporation and Olympus Corporation have occurred in Japan, leading to discussions on how corporate governance should be strengthened. At the end of last year, the Ministry of Justice published a draft proposal on the revision of the Commercial Act that obligated large companies to have outside directors, to which the business community, including the Japan Federation of Economic Organizations (Keidanren), has expressed strong opposition. Recently, the media has been reporting that the Democratic Party of Japan is expected not to mandate companies to have outside directors.
The boosting of outside directors and the enhancement of their independence are frequently proposed as the key to corporate governance reform, not only in Japan but also elsewhere. However, when designing a system associated with corporate governance, it is necessary to consider not only its effect on the deterrence of scandals but also on business performance and on the economy as a whole.
There has been much research on whether or not the introduction or the increase of outside directors improves company performance. For example, there has been analysis on the effect of appointments of outside directors on share price and on the relation of the number of outside directors to company profitability. Their conclusion, in sum, is that the optimal number of outside directors or the optimal degree of their independence differs depending on the characteristics of individual companies; it is not always true that an increase in the number of outside directors is desirable. For example, for R&D-intensive, or young and rapidly growing companies, fewer outside directors and less independent boards are more suitable. (Coles et al. (2008); Linck et al. (2008), among others)
Relation of outside directors to productivity in Japan
The "Basic Survey of Japanese Business Structure and Activities," a major statistical survey of businesses in Japan compiled by the Ministry of Economy, Trade and Industry, from FY2009 has added to its research items the number of inside and outside directors as well as the number of outside directors who are concurrently directors or employees of affiliated companies. Its result indicates that, on average, 81.2% of directors are inside and 18.8% are outside. Of the outside directors, more than half (57.6%) are directors or employees of affiliated companies.
Using the micro-data from these statistics, I observed the relation of the number and attributes of outside directors to productivity. By controlling for differences in size and industry sectors, a statistically significant relationship between the number of outside directors and the company's productivity has been found. Quantitatively, one additional outside director increases both total factor productivity (TFP) and labor productivity by more than 2%. This analysis is, of course, a simple cross-sectional correlation. In reality, as the appointment of an outside director in itself is an endogenous variable, the possibility of a reverse causality relationship, with productivity as the cause and outside directors as the effect, cannot be excluded. On the other hand, if companies tend to appoint outside directors at times of worsening performance, these numbers could be underestimated. The research also demonstrated that one additional outside director who is concurrently a director or employee of an affiliated company improves productivity by approximately 4% while the relation of other outside directors to productivity is small and statistically insignificant. (Please see the following figure.)
Lessons for Japan from experiences in other countries
The above data indicate: (1) on average, Japanese companies have an insufficient number of outside directors, and it is desirable for them to increase this voluntarily; and (2) in terms of the attributes of outside directors, those who are knowledgeable on the operation of the company are suited. As enhancements of outside directors' functions are often discussed in the context of corporate scandals, purely external, highly independent individuals, such as lawyers, tend to be considered as desirable candidates, but that is not necessarily true from the perspective of company productivity.
In the United States, the enactment of the Sarbanes-Oxley Act of 2002 (SOX) and related institutional reforms of stock exchanges, brought about by the Enron incident, led to the introduction of a rule requiring listed companies to set up audit committees comprised of independent directors. However, there have been empirical studies demonstrating that SOX has had negative impact such as worsening profitability and cost increases (Ahmed et al. (2010); Linck et al. (2009); Duchin et al. (2010)). Moreover, Fracassi and Tate (2012) pointed out that, despite the drastic increase of independent directors as a result of the enactment of SOX, many of them had personal connections (through activities at sports clubs, charities, etc.) with the CEOs, indicating discrepancies between legal independence and actual independence.
Ahern and Dittmar (2012) recently conducted an analysis on the Norwegian legislation enacted in 2003 which requires 40% of directors to be women. The result showed that company valuation declined significantly due to the rapid increase of female directors with insufficient management experience. Although this study does not limit its scope to outside directors, it proves the negative effect of imposing any quota on companies that deviate from the optimal composition of directors.
These empirical research conducted overseas provide useful information for Japan in designing its laws and regulations related to corporate governance. Scandals tend to prompt for calls of reinforcement of compliance and often lead to tighter government regulations. However, the tightening of regulations comes with added costs. From the perspective of productivity, responses should take the heterogeneity of companies into consideration.
- Ahern, Kenneth R. and Amy K. Dittmar (2012), "The Changing of the Boards: The Impact on Firm Valuation of Mandated Female Board Representation," Quarterly Journal of Economics, Vol. 127, No. 1, pp. 137-197.
- Ahmed, Anwer S., Mary Lea McAnally, Stephanie Rasmussen, and Connie D. Weaver (2010), "How Costly Is the Sarbanes Oxley Act? Evidence on the Effects of the Act on Corporate Profitability," Journal of Corporate Finance, Vol. 16, No. 3, pp. 352-369.
- Coles, Jeffrey C., Naveen D. Daniel, and Lalitha Naveen (2008), "Boards: Does One Size Fit All?" Journal of Financial Economics, Vol. 87, No. 2, pp. 329-356.
- Duchin, Ran, John G. Matsusaka, and Oguzhan Ozbas (2010), "When Are Outside Directors Effective?" Journal of Financial Economics, Vol. 96, No. 2, pp. 195-214.
- Fracassi, Cerare and Geoffrey Tate (2012), "External Networking and Internal Firm Governance," Journal of Finance, Vol. 67, No. 1, pp. 153-194.
- Hermalin, Benjamin E. and Michael S. Weisbach (2003), "Boards of Directors as an Endogenously Determined Institution: A Survey of the Economic Literature," FRB New York, Economic Policy Review, Vol. 9, No. 1, pp. 7-26.
- Linck, James S., Jeffry M. Netter, and Tina Yang (2008), "The Determinants of Board Structure," Journal of Financial Economics, Vol. 87, No. 2, pp. 308-328.
- Linck, James S., Jeffry M. Netter, and Tina Yang (2009), "The Effects and Unintended Consequences of the Sarbanes-Oxley Act on the Supply and Demand for Directors," Review of Financial Studies, Vol. 22, No. 8, pp. 3287-3328.
Fellow titles and links in the text are as of the date of publication.
For questions or comments regarding RIETI Report, please contact .
RIETI Report is published monthly.