Corporate Governance

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Corporate Governance

• Handout 2

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The board of directors system reform in Japan

• There are some differences between the board of
  directors systems in Japan and in the US.

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Board of directors (US system)
Shareholders
Board of Directors
Elect
Report
Elect
Shareholders elect the board of directors. The
board, then elects the CEO and other officers.
The board acts as a monitoring system. If the
elected officials do not act on behalf of
shareholders, the board has the right to replace
the management . Thus, the board of director
system can potentially alleviates the conflict of
interests.
Management CEO
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• In the US, in principle, management is separated
  from the board of directors. This separation
  ensures that the board of directors can
  effectively monitor management.
• However, in Japan, the system is different.

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Board of directors system in Japan
The board of directors (Torishimari Yaku
kai) President (Shacho) Managing director
(Senmu) Executive Director (Joumu)
Shareholders
Elect
Select from within
The board of directors select President and other
executive directors from within the
board. President handles day-to-day business.
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• Similar to the US system, by law, the board of
  directors acts as a monitoring system to ensure
  that managers act on behalf of stakeholders.
• By law, the board of directors monitor managers
  (Presidents etc), and if necessary, replace
  management.
• A fundamental difference is that, elected
  managers are also the members of the board. Thus,
  in Japan, there is no separation between the
  management and monitoring system.
• There are other characteristics of Japanese
  board, which are summarized in the following
  slides.

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Some characteristics of the board of directors in
Japan

• Most of the directors are promoted from within
  the company.
• Large.
• 60 of large companies (capital greater than
  500 billion yen) in 1995 had board with more than
  30 directors. It was not uncommon to see a board
  with 40 directors or 50 directors.
• Many directors are also employees of the company.
  They are typically the top managers of
  departments within the company.

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• Japanese board of directors system has its
  problem but there can be some benefit as well.
• Let us consider some possible benefits of this
  system, and its potential problems.

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Some benefits of the Japanese board of directors
system

• Since it is large, and most of the directors are
  promoted from within, there are greater chances
  for employees to be promoted to the position of a
  director. Greater chance of promotion has
  positive incentive effects.
• Greater change of promotion also provides
  incentive for employees to acquire skills that
  are specific to the company. This also reduces
  turnover rate.
• Since most of the directors are also employees of
  the company, this makes it possible to utilize
  information from actual workplace.

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Some problems of the Japanese board of directors
system

• It is large. Therefore, it is difficult to make
  speedy decision.
• Many directors are also the top managers of
  departments within the company. They tend to
  place a priority to the interest of his/her
  department. Conflict of interests among directors
  make difficult to come up with a unified
  decision.

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Some problems of the Japanese board of directors
system (Contd)

• Many directors are also employees of the company
  who report to the president. Thus, although the
  board if directors is required to monitor the
  management (president, etc), it is impossible to
  effectively monitor the management.
• Similarly, since the elected managers are also
  the members of the board, this system is a
  self-monitoring system, which reduces the
  effectiveness of monitoring.

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• The problems of the Japanese board of directors
  system began to be recognized in the late 1990s,
  and some company began to reform the system. In
  particular, several companies began to introduce
  US style Chief-Officer System (Shikkou Yakuin
  Seido), where management is separated from the
  Board of directors.
• The first company to introduce such a system was
  Sony. Sony introduced Chief-Officer system in
  1997. At the same time, it reduces the size of
  the board from 38 to 10, and increased the number
  of outside directors.

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• Today, we will investigate
• (1) what companies are likely to adopt the
  Chief-Officer system (Shikko-Yakuin Seido). More
  specifically, we investigates the determinants of
  the adoption of Chief-Officer system.
• (2) Whether the adoption of Chief-Officer system
  would enhance company performance.

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What companies are likely to adopt Chief-Officer
system.

• The discussion below will be based on Aoki
  (2002).
• For investigation, we will use the sample of
  manufacturing companies that are publicly traded
  at the Tokyo Stock Exchange.
• Only the companies whose size (in terms of sales,
  capitalization, and number of employees) are in
  top 300 are used for investigation. The period of
  analysis is between 1995 and 2002.

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The trend
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Hypotheses

• Before analyzing the determinants of the
  introduction of Chief-Officer system, we first
  need to think of the potential determinants of
  the introduction of the Chief-Officer system.
• The following slides summarizes the potential
  determinants.

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Hypotheses (Contd)

• Size of the board
• Larger board size reduces the effectiveness
  of the board as a decision maker and as a
  monitoring system. Thus, when the board is large,
  this may create pressure to introduce
  Chief-Officer system in order to create effective
  management system.

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• Diversification
• When a company has diversified businesses
  (when a company has many group companies within
  etc), each director may place priority to
  his/her own group, creating conflict of interests
  within the board. In this situation, a
  Chief-Officer system that places management
  outside the board would be more beneficial.

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• Foreign investors and institutional investors
• Foreign investors and institutional
  investors may voice their opinion to introduce
  the Chief-Officer system, and this may prompt the
  companies to introduce the system.
• Investment opportunities.
• A company with greater investment
  opportunity may be more likely to introduce such
  a system in order to attract investors.

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• The existence of alternative corporate governance
  system.
• Main bank system, or cross-shareholding have
  been considered as alternative corporate
  governance system in Japan where main banks or
  the parent company monitor the company. When an
  alternative system is present, the company many
  not need to have the chief-officer system Thus,
  a company with main bank or with a parent company
  may be less likely to introduce a chief-officer
  system.

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• Now, we will consider if the above hypotheses are
  supported by data.
• In order to do so, we consider the following
  variables in a regression analysis.

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Empirical analysis

• Aoki (2002) estimates the following model.
• Ytß0ß1(OPR)t-1ß2(DS) t-1
• ß3( NOB) t-1ß4(DIV) t-1ß5(FORE) t-1
• ß6(INST) t-1ß7(INV) t-1
• ß8(MB) t-1ß9(SUB) t-1ß10(OPR)
  t-1ß11(DS) t-1
• Yt is a dummy variable that takes 1 if the
  company introduced Chief-Officer system at year
  t, and 0 otherwise. So this regression estimates
  the effect of each variable on the probability of
  the introduction of the chief-officer system.
• Note the actual estimation is done using a
  model called the logit model which is slightly
  different from above description. However, the
  interpretation of the model is the same.

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Analysis using sample from 1997 to 1999
Negative coefficient Company introduces the
Chief officer system subsequent to bad
performance.
When the board size is large, company is likely
to introduce the chief-officer system
Diversified company is more likely to introduce
the system
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Analysis using sample from 1997 to 1999
The existence of foreign investors has no effect
on the adoption of the chief-officer system.
Institutional investor has no effect.
Main bank has no effect Parent company reduces
the likelihood of adopting the system
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• Deterioration in firm performance is one reason
  why firms adopt chief-officer system.
• The companies that are more likely to benefit
  from chief-officer system (the large board size,
  diversified business) indeed have a higher
  probability of introducing chief-officer system.
• Institutional investors and foreign investors do
  not have significant effect on the introduction
  of chief-officer system. This shows that the
  board of director reform is not a result of
  outside pressure.
• Those who already have some corporate governance
  system (existence of parent company) are less
  likely to adopt chief-officer system
• To sum, companies introduce a chief-officer
  system because they need it (due to a bad firm
  performance, or absence of effective governance
  system), and not because of outside pressure.

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The effect of chief-officer system on firm
performance.

• Next question is, whether the introduction of a
  chief-officer system really improves firm
  performance.
• Aoki (2002) investigates if an introduction of a
  chief-officer system would improve firm
  performance.
• Next slide shows again the variable definitions.

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• Aoki (2002) investigate if an introduction of
  chief-officer system improves subsequent firm
  performance by running the following regression.
• (OPR)t1ß0 ß1(EOS)t
• ß2(OPR)t ß3(DS) t
• ß4( NOB) t ß5(DIV) t
  ß6(FORE) t
• ß7(INST) t
  ß8(INV) t
• ß9(MB) t ß10(SUB) t
  ß11(OPR) t ß12(DS) t
• Where (EOS)t is a dummy variable that takes 1
  if the company introduces chief-officer system in
  year t. Thus, this regression estimates the
  effect of an introduction of chief officer system
  on the firm performance (OPR) one year after the
  introduction.

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Effect of chief-officer system on firm
performance one year after the introduction of
chief-officer system
The board size has negative effect on performance.
OPR
Diversification does not have impact on firm
performance.
Surprisingly, the effect of main bank is negative.
We do not find positive effect of the
introduction of chief-officer system. In fact,
the estimated coefficient shows negative sign
(meaning an introduction of the system decreases
the firm performance). This may be because, it
takes time for the effect of chief-officer system
to take place. Next slide shows the effect on
the firm performance two years after the
introduction of the chief officer system.
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Effect of a chief-officer system on firm
performance two years after the introduction of
chief-officer system
OPR
The effect of an introduction of a chief-officer
system still has no significant effect on firm
performance.
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Why a chief-officer system does not improve firm
performance.

• One possible reason may be that, chief executive
  officer may still be a member of the board of
  directors. Then, the board of director cannot
  monitor effectively.
• Aoki (2002) note that nearly 80 percent of
  chief-officers are also members of the board of
  directors. This means that, even if many
  companies have introduced the chief-officer
  system, the situation did not change much from
  the old system.
• Probably because of this, we did not find
  evidence that the introduction of a chief-officer
  system improves firm performance.

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• Reference
• Aoki, Hidetaka (2002) ????????????????????????????
  ?(The determinants of the adoption of the
  chief-officer system and its effectiveness)?
  Waseda Institute of Finance, Working Paper
  Series, WIF-03-007