Growth and corporate governance

The importance of the role of independent directors

LAST year, I wrote that for South Korea to become more innovative and competitive, it needs to effectively implement corporate governance laws and regulations that are transparent and disclosure based, rather than merely merit based (which relies too much on the value judgements of bureaucrats).

Just returned from brain storming among 24 academic experts from 15 countries on the Asian Shadow Financial Regulatory Committee (ASFRC) at Hitotsubashi University in Tokyo.

The focus was on the unique features of corporate governance issues in Japan, in particular the impact of the role of board independent, outside non-executive directors (Indies) on the delivery of growth, investment, innovation and productivity.

Current situation

Basic issues in corporate governance continue to remain worrisome in both emerging and advanced Asian economies, including Japan. The Japanese Corporate Governance Code took effect in June 2015 and has been since amended, including recommending the composition of Indies be raised to one-third. Although compliance is voluntary, support of both the Tokyo Stock Exchange (TSE) and Regulators appears to have created a momentum exerting pressure on companies to comply.

Nearly 90% of TSE listed companies already had Indies by 2015. According to the 2016 Bain report, S&P500 Indies hold an average of 84% of corporate board seats, compared with only 23% for the Nikkei 225 listed companies in 2014.

In addition, most US Indies have executive management experience. The average S&P500 listed company has 6.5 Indies with business experience, against only 1.2 in Japan.

Traditionally, the problem of Japanese corporate governance has been too much insider control by banks and corporations. With the emergence of foreign institutional shareholdings, this concern has since moved to how to retain stable shareholdings. However, it is still worrisome that Japanese companies are excessively insider-dominated, as demonstrated by the cases of Olympus and Toshiba, with inadequate sanctions being imposed for poor Japanese management.

Still, corporate governance reforms have remained a key part of Japan’s growth strategy. Deleveraging has since accelerated. This trend in Japan is rather different from that in United States. It contrasts with the traditional view of US as an equity-based system and Japan as dependent on bank borrowing and therefore, highly leveraged.

However, with the recent collapse of the Japanese banking system, leverage declined appreciably, and equity financing rose. This change is associated with a decline in the traditional close relations between banks and companies in Japan.

As I see it, this falling leverage should not be detrimental provided they are combined with appropriate forms of governance by shareholders. In essence, Japanese policy can be characterised as having moved from debt to equity governance, in the same way the US moved from traditional equity to debt governance.

The effect has been to replace what were previously relatively conservative bank shareholders with more risk-tolerant outside institutional investors. This encourages Japanese corporations to undertake more investment and adopt more innovative policies that pose greater risks, but also offer the prospects of higher growth and earnings in the future.

Second, the recent trend in Japan involves the dramatic change of ownership structures. Insider ownership characterised by cross shareholdings between banks and firms is no longer the main trajectory. Outsider – in particular, foreign – institutional ownership has been increasing. Foreign investors are independent and provide an important independent & transparent oversight of companies.

However, their “distance” from domestic firms also means that governance by them is weaker than that of domestic institutions, while their dispersed ownership makes it difficult for them to exercise effective governance, except through the downward pressure on share prices. Furthermore, foreign institutional investors are fickle, tending to flee when conditions deteriorate.

Therefore, they do not provide stability in shareholding and promote undue focus on short-term issues. Accordingly, it would seem that a combination of stable domestic shareholdings alongside foreign institutional investments is required to provide an appropriate balance of insider and outsider monitoring and control.

Third, the role of Indies is critical in the UK and US context in terms of providing an outside perspective and independent advice on the running of the firm. Indies are regarded as critical in avoiding possible conflicts that exist between shareholders and management. In concentrated ownership systems such as that in continental Europe or Korea, Indies play a different role of protecting minority shareholders against controlling (often family) owners.

In Japan, the role of Indies is predominantly to reflect the interest of the outside (foreign) institutional investors. One way in which they exercise this power is through the nomination of new directors and presidents. In Japan, this can lead to conflicts between the succession interests of traditional insiders and outside directors as representative of outside shareholders.

Striking the right balance will be difficult in a hybrid system that combines inside interests with outside institutional investors. However, that tension can have some potential benefits.

Fourth, cross shareholding is still a unique feature of Japan, although its level has declined substantially. While there has been an unwinding of bank shareholdings of companies, cross shareholdings in Japan remain important. Similarly, in Germany, while there has been an unwinding of bank holdings of German corporate equity, family holdings remain important. Requiring firms to justify their cross shareholdings may be beneficial, but ultimately Japanese companies will continue to employ them when they are perceived to be necessary for promoting the long-term interest of firms.


Effective use of Indies requires cultural change. In particular to bridge the gap between governance and execution. Japanese top management appears to fear the views and possible criticism of outsiders even though outsiders bring in new perspectives. That is why they need to be treated with an attitude of acceptance and inclusion. Also, educating them on company culture.

At their best, they serve as a check-and-balance providing oversight of executive actions and offering objective, unbiased critique. If Indies understand the firms’ culture and strategic priorities, they can better assist the firm to grow, while maintaining their distinctive spirit and inner strengths.

So, it is important for Japanese corporations to develop a proper governance mindset to effectively enhance governance and execution. Companies should seek out independent points of view from outside directors to provide oversight and advice on strategy. Also, to avoid conflicts between insiders and outsiders.

In addition, Indies should work towards owning the processes of CEO appointment, succession, compensation and performance review. Japanese corporations face many challenges in shifting to this ideal management structure, including overcoming the traditional employee-driven nature of many Japanese companies. Also, in moving from an individual-based approach to a more systematic, balanced governance model, and swapping talent to prevent “staleness” from setting in.

The evolution will not be easy and takes time. Many companies will face internal biases and suspicions on the views of Indies. Furthermore, while the various definitions of Indies are well documented, their application in practice to appoint “truly independent” Indies poses problems. Unless this is effectively resolved, their desired effect may not be achieved.

The US corporate board governance model is based on the concept of monitoring and advising by Indies. Hence, Indies dominate their boards. In contrast, corporate boards in Japan are insider-dominated, emphasising more on talent development and succession planning. Managers who have a board seat compete among themselves for the position of chief executive.

This is unique to Japan and can be a source of value. Empirical evidence demonstrated that, in Japan, the percentage of inside directors younger than the CEO is positively correlated to the firm’s performance. Also, the percentage of junior inside directors is positively related to the frequency of management turnover.

US and European corporate governance practice has shown that a larger number of Indies is not necessarily value enhancing. In some cases, a larger number of inside directors can add higher value, especially among R&D-intensive firms. So, “one-size-fits-all” cannot be expected to have universal application, including in US. As such, Japan should not necessarily be concerned if its own standards of corporate governance differ from those of the US and Europe.

What then are we to do

The ASFRC is right in their views on corporate governance reform, concluding that: (i) Japanese companies should seriously consider setting their own optimal board composition, including the number & role of Indies taking into account their company characteristics. What’s really needed is to have a well-balanced board with diverse knowledge, experience and skills to fulfill its role and discharge its responsibilities; (ii) Here, it is critical for regulators to strategically think-through and clearly define the concept of Indies to facilitate easy and consistent application in practice; and (iii) Furthermore, companies must always endeavour to seek highly qualified, capable Indies with relevant experience.

A clear and independent process for evaluating their performance should also be established. Lest we forget, the focus of economic policy for Japan (and Malaysia) is to remain active in promoting growth and raising productivity. Hence, corporate governance reforms must be concerned with the delivery of growth & the reduction of inequality. After all, corporate governance interfaces among companies, economies and societies, not just between firms and investors.

By focusing on the latter, corporate governance often ignores the former thereby undermining the real contribution that the corporate sector makes to economic and social wellbeing. In the final analysis, we need to ensure that corporate governance assists Japan and Malaysia in addressing fundamental economic issues that confront them in the future.

Former banker, Harvard educated economist and British Chartered Scientist, Tan Sri Lin See-Yan is the author of The Global Economy in Turbulent Times (Wiley, 2015) & Turbulence in Trying Times (Pearson, 2017). Feedback is most welcome.

Lin See Yan