What is the Value of Independent Directors? – of Statutory Auditors?

According to some academics, there is goodstatistical evidence of a correlation between the presence of parent companies and PE funds and superior firm performance, but the evidence is weak that the presence of independent directors improves firm performance.

In Japan, whereconstitutencies that prefer a comfortable status quo usually demand advance proof (precisely because itis impossible)of the advantages of any particular reform, itisinevitable that this debate will affect the current deliberations of the Legal System Advisory Council's Subcommittee on the Company Law. Such parties usuallyinsist that Japan is different where foreign examples might clearly undermine their arguments, but theyconveniently demand for proof from foreign markets when the data are less clear.For some reason,Japan is suddenly no longer culturally different in the lattercase.

Some related thoughts and topics:

1) In a fascinating paper, Professor Randall Morck of the Alberta School of Business has theorized that the reasons for the absence ofstrong evidence for the effectiveness of independent directorsmay be either that: a) insufficient time has elapsed to show the effects of active independent directors; orb) that deeper reforms, such as letting public shareholders nominate candidates for directors, may be needed in order to overcome the innate human disposition to obey authority figures. This point of view suggests that even inforeign countries, such as the U.S., most independentdirectors are not independent enough.*

Professor Morck's observations areparticularly relevant in thecontext of Japan, where group thinking and the innatehuman disposition toobey authorityrunstrong,but where the Company Law has permitted very convenient access to the proxy for many years.One implication is that if there were a mandatory requirement for independent directors and a Stewardship Code with stronger fiduciarly obligations on the part of institutional shareholders,in Japan the conditions may already exist for independent directors to become more effective than in foreign countries. Under these conditions, unless management proposes independent directors which are convincingly independent and sincere about performing the role, it willhave to fear opposing nominations by way of shareholder proposals. Clear best practice directionregarding expected roles and standards for independent directors mightaugment this,byproviding an offsetting obedience motivationand taking advantage ofthe high cultural desire ofJapaneseto avoid reputation risk.

2) A related issue is, is itrealistically possible – ormeaningful – toinsist onstatistical proof ofpositive impact on firm peformance from a single factor in a sea of other governance factors,many of which are dynamicallyrelated, and exist in a much larger sea of other factors that affect managerial performance? In other words,it islikely that there istoo muchdata static, and you would never expect the relationship to be as strong as in asingle-owner dominated firm in the first place.Therefore,a frequently-voiced opinion is that it is much more important to simplyask what is the best way for Japanto recover the confidence of the market and investors, and reduce to a minimum incidences of scandal, malfeasance, or sub-optimal managerial peformance? It is indisputable that global converance and recovery investor confidence in Japan's markets are very important. And the fact is,world-wide, the largest institutional investors are saying that Japan needs to require independent outside directors.

3) In Japan, one often hears the question, can you show'proof' that the independent directors bring concrete value? However, the same persons never ask for evidenceof any relationship betweenstatutory auditors and firm performance. Why is that? One might say that we should simply look at the reality of the past 20 years, and ask ourselves how much positive value was preserved or brought by statutory auditors. And then again,no one never asksfor evidenceof the concrete value ofdetailed disclosure by listed companies.

4) Last, there are issues that relate to the market for corporate control, whichhardly everfunctions effectivelyin Japan, but would help Japan's economy if it did. Ifnot independent directors acting in committees, whowill be the neutral party who determines what is a sufficient price for the MBO, or whether or not to deploy the poison pill? Who will determine compensation matters, and board nominations? The present Japanese corporate governance system has resulted in lawsuits aboutlow MBO pricing,squeeze-out pricing.Another result has been lockstep, hierarchical compensation for directors that is almost entirely incash and which only has a small performance-based component. Is there anyreason to think that these aspectswill change if the fundamental problem in the system is not addressed? Clearly, to shareholders,profitablity is not the only measure of firm performance that matters. Whether one gets paid out fairly when the company is bought out or mergedbased onmanagerial preferences, would seem to matter as well.When they look at firm performance, isanyone measuring the opportunity costs of: a)those corporate control transactions that should have occurred, but were offered and refused by management; b)low pricingfor the few transactions that did occur?In this light,it is pertinent toconsider thathistorically, TOB premiums inJapanhave tended to be near zero, or negative, depending on when one measures them.

In the interests of deepening debateas revision of theCompany Law is being considered, we encouragereaders to sendtheir comments and opinions on these topics.

BDTI Administration

* In Behaviorial finance in corporate governance: economics an ethics of the devil's advocate, 2008. Professor Morck wrote:

Misplaced loyalty lies at the heart of virtually every recent scandal in corporate governance. Corporate officers and directors, who should have known better, put loyalty to a dynamic Chief Executive Officer above duty to shareholders and obedience to the law. The officers and directors of Enron, Worldcom, Hollinger, and almost every other allegedly misgoverned firm could have asked questions, demanded answers, and blown whistles, but did not. Ultimately they sacrificed their whole careers and reputations on the pyres of their CEOs.

Loyalty is an important virtue. It makes possible the large hierarchical
organizations that underpin national economies: armies, government bureaucracies, universities, political parties and corporations. But loyalty—to political ideologues, religious zealots, ethnic purists, and other militants—also underlies the most horrific chapters in history books. Corporate governance scandals are minor misdemeanors in this company, but the underlying problem of misplaced loyalty is the same.

Much work in empirical social psychology suggests that loyalty is emotionally hardwired into human behavior. Milgram (1963, 1974) shows that a human subject suppresses internal ethical standards surprisingly readily if these conflict with loyalty to an authority figure. This accords well with officers and directors’ stalwart loyalty to misguided or errant CEOs, even under clear signs of impending financial doom. Milgram argues that loyal behavior stimulates feelings of well-being, and that this reflects evolutionary pressure on early human societies, when obedience to authority wrought social organization that raised survival odds (Hobbes 1651).

In the modern world, more nuanced obedience to authority is increasingly required. Corporate governance reformers, in particular, seek to weaken this innate response at selective points in corporate hierarchies. Milgram (1974) finds that dissenting peers and rival authorities undermine subjects’ loyalty, and stimulate independent moral reasoning. Corporate governance reforms that envision independent directors (dissenting peers) and non-executive chairs (alternative authority figures) aspire to a similar effect on corporate boards—a fostering of debate to expose flawed policies before they become lethal—in order to render corporate governance disasters rarer. In this vein, the Higgs Report proposes that listed company boards in the United Kingdom have non-executive chairs and senior independent directors, and the Sarbanes Oxley reforms in the United States require that boards contain enough independent directors to staff key board committees.

In light of these findings from social psychology, the inability of economics and finance to detect consistent linkages between board independence and corporate performance is puzzling. There are two plausible reasons for this.

One is that insufficient time has elapsed to show the effects of active independent directors. Many of the directors classified as independent in corporate proxy statements may in fact be deeply beholden to the CEO. The Higgs report finds that almost half the so-called independent directors on British boards were recruited by the CEO through personal contacts or friendships. A mere four percent had a formal interview. This renders nominally independent directors beholden to CEOs. As more stringent definitions of independence apply, a clearer relationship with firm performance may emerge.

A second plausible reason is that behavioral constraints on board independence are deep. Deeper reforms, like letting institutional investors and public shareholders nominate candidates for elections to boards, may thus be needed to foster genuinely independent directors and board chairs. Institutional investors too are only tenuously linked to firm performance. This may reflect governance problems within institutional investors (Lakonishok et al. 1992) or their inability at present to affect many boards.

The Board Director Training Institute (BDTI) is a "public interest" nonprofit in Japan dedicated to training about directorship, corporate governance, and related management techniques. It is certified by the Japanese government to conduct these activities as a regulated nonprofit. Read a summary about BDTI here, and see a menu of its services for both corporations and investors here.


  1. In the web magazine of the National Association of Corporate Directors, there are two good articles on the "lessons" to be drawn  (for U.S. boards and managers)  from the Toyota debacle.

    In a sense the question could be rephrased as, "what's the value of doing your best to avoid a crisis like this"? It would seem that no manager in any country can ever pat himself on the back and think that he already has the perfect corporate governance system and has implemented it optimally. Doesn't it go without saying that human knowhow and technology – including organizational design – can always be improved more, and mankind has only just begun to improve corporate governance?

    One of the articles writes, "These U.S. reforms [NYSE listing rules and SOX] were adopted in the face of vocal opposition. Critics argued that empirical research offered little support for the proposition that director independence leads to improved firm performance. They also argued, in a vein consistent with traditional Japanese views, that it is more difficult for independent board members lacking operational expertise to make meaningful contributions to company decision-making.

    Toyota’s current crisis provides lessons for our own debate over board independence.  Toyota, Japan’s largest and most respected corporation and an emblem of Japanese manufacturing prowess, has long been successful in global markets.  However, Toyota’s recent troubles indicate the limits of relying on competition in product markets and team production alliances to monitor management and provide effective corporate governance in an insider-dominated system.

    Whatever direct harm might have been caused by the apparent defects in Toyota’s manufacturing processes, Toyota’s current crisis has been compounded by the apparent unwillingness of corporate management to address public concerns and to engage with legislators and regulators.  This raises the question of whether the Company’s secrecy and apparent stonewalling was fostered by the lack of independent management oversight on Toyota’s board.  Without oversight from directors who are not directly tied to the interests of management, there may be little incentive or opportunity within a corporation to address criticism of corporate activities.

    The tension between board independence and operational efficiency is by no means a peculiarly Japanese phenomenon. American directors and investors should make efforts to ensure that a desire to ensure directors’ familiarity with operational details does not overwhelm the need for effective management oversight.

    The two articles are available at:



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