Introduction: Increased importance of institutional investors and outside directors

Currently, Japanese firms are once again facing major changes in corporate governance, the first such changes since the late 1990s. The Japanese Stewardship Code was released in 2014 as a code of conduct for responsible institutional investors. In 2015, a year designated as the first year of the corporate governance era, the Companies Act was amended to strongly recommend the appointment of outside directors per the “comply or explain” rule. Additionally, as listing rules of the Tokyo Stock Exchange, the Corporate Governance Code which requires measures including the appointment of at least two independent outside directors was enacted. These changes demonstrate the increasing importance of institutional investors and outside directors to corporate management. In this article, I will examine the actual extent to which management decision-making is impacted by the form of corporate governance.

Decision-making of managers is reflected in diversification

One important issue of corporate governance is the effectiveness of disciplinary mechanisms targeting the managers who rule over organizations known as corporations and who possess substantive authority/responsibility for decision-making. For example, assuming that a mechanism exists for replacement of managers due to declining business performance, do managers make every possible effort to increase performance without falling into lax management? Actually, this relationship has been confirmed in many prior studies. However, if poor firm performance causes presidential turnover, strategy must be reviewed prior to the replacement.

Now, who would decide on this strategic change? Of course, the answer is top management. There are cases in which it is difficult to delegate authority to individual business units, and the responsibility for decision-making must be assumed by top management. Some typical examples of the decision-making in such cases include decisions regarding which businesses will be held by the overall corporation and coordination across divisions. Managers make decisions regarding the selection of businesses (entry into new businesses and withdrawal from existing businesses) and concentration of management resources (people, goods, money, etc.) to businesses with high levels of competitiveness. These decisions are reflected in diversification of the business portfolio.

Mechanisms for changing strategy: Corporate performance and governance structure

This research treated changes in diversification as the result of strategic decision-making by managers and focused on verifying how said decision-making is affected by the structure of corporate governance. For example, managers most likely feel pressure of having to change strategy when organizational performance begins to decline. It can be inferred that autonomous governance is functioning at firms where its strategy is reviewed in response to declining organizational performance.

Now, at this time, the pressure felt by managers may be alleviated when there are a large number of stable shareholders who remain silent. Conversely, the pressure felt by managers can be expected to increase when there are a large number of outspoken shareholders or when there are outside directors on the board of directors. In this way, it can be theorized that while the structure of traditional Japanese-style governance dulls the sensitivity of managers in terms of recognizing current conditions, this sensitivity is intensified by pressure from the capital market (shareholders) and a board of directors with enhanced functionality for strategic decision-making and monitoring. Accordingly, we tested this relationship by using 22 years of data (from fiscal 1990 to fiscal 2011) from the firms on the First Section of the Tokyo Stock Exchange (excluding financial institutions).

Results of empirical analysis: Adverse function of Japanese-style governance and management disciplinary mechanisms

Firstly, changes in strategy were made systematically in response to a decline in corporation performance. Accordingly, it can be said that worsening corporate performance causes managers to feel pressure of having to revise strategy.

Secondly, we confirmed the adverse function of traditional Japanese-style corporate governance. The cross-shareholding and large-scale boards of directors had the negative effect on flexible changes in corporate strategy. They interfered with the strategic change sensitive to declining corporate performance, and helped to preserve current strategy. Therefore, the decision of Japanese firms to streamline the board of directors can be deemed as rational from the perspective of improving the strategic decision-making function. Moreover, it can be said that stable shareholders through cross-shareholdings alleviate pressure from capital markets to cause managers to underestimate the necessity of reform.

Thirdly, as the result of analysis focusing on low-performance firms, we were able to identify governance factors which have the effect of management discipline. Strategic change sensitive to declining organizational performance is encouraged at firms with a high ratio of outside directors in which monitoring and advice for management are considered to be well-functioned. The same is encouraged at firms with a high ratio of activist investors (foreign shareholders, institutional investors, etc.) in which managers are exposed to strong pressure from the capital market.

Conclusion: Governance affects strategy

The fundamental conclusion is that corporate governance affects strategy. However, caution is required for the following two points;

Firstly, the structure of corporate governance does not constantly affect corporate strategy. The effect of governance was obvious from the late 1990s to the early 2000s. During this period, the structure of governance at Japanese firms changed drastically and it can also be assumed that managers also had a high level of awareness towards the new form of corporate governance. Traditional Japanese-style governance was characterized by stable shareholders through cross-shareholding, main bank monitoring, and large-scale boards of directors which consist mainly of promoted insiders. During the period of change, this traditional style was imbued with new characteristics such as elimination of cross-shareholdings, increased presence of foreign shareholders and institutional investors, downsizing of boards of directors, separation of management and implementation through the introduction of executive officer systems, and strengthening of monitoring and advice functions by outside directors. Besides, this new governance structure possesses stronger disciplinary functions toward managers.

Secondly, the effect of corporate governance on strategy cannot be clearly confirmed when firm performance is favorable. Stated differently, the effect of governance was obvious when firm performance did not reach certain standards. The true value of corporate governance is questioned when problems exist within an organization, not when performance is favorable. Accordingly, there was great meaning in confirming the effect of corporate governance in situations where reform was required. Furthermore, we could find governance factors which have a disciplinary effect on management, when corporate performance was poor. This fact is important.

Concluding remarks: The keys to disciplinary mechanisms

In regards to Japanese corporate governance, a long time has passed since the effect of main banks was said to have declined. However, governance mechanisms which have a disciplinary effect on management when financial conditions are poor have been observed even after the 1990s. This is also an important fact. The keys to these disciplinary mechanisms were external governance consisting of pressure from the capital market and strengthening of internal governance by reforming the structure of top management (streamlining the board of directors, hiring outside directors, etc.). Doesn’t this sound like current conditions?

*This column introduced a summary of Corporate Strategy and Corporate Governance in Japan; An Empirical Study on Diversification (Chuokeizaisha, 2017) by Hidetaka Aoki.

Hidetaka Aoki
Professor, Faculty of Policy Studies, Chuo University
Areas of Specialization: Corporate Governance and Management Studies

Hidetaka Aoki was born in Tochigi Prefecture. He graduated from the Waseda University, School of Commerce. He finished the Doctoral Program in the Waseda University, Graduate School of Commerce. He holds a PhD in commerce. Before assuming his current position, he served as a Research Associate in the Waseda University, School of Commerce; Professor in the Chiba University of Commerce, Faculty of Commerce and Economics, and Graduate School of Commerce, and Associate Professor in the Chuo University, Faculty of Policy Studies.
Main works
“Corporate Governance and Accounting Fraud : Is Governance Reform Effective?”, in Corporate Governance and Growth Strategy, edited by Hideaki Miyajima, Toyo Keizai Inc., 2017(in Japanese)
“The Effects of Corporate Governance Structure on Strategic Change: An Analysis of Diversification Strategy”, Journal of Business Management, 34, 2014 (JABA Award) (in Japanese)
“Benchmarking Business Unit Governance in Turbulent Times: The Case of Japanese Firms”, Benchmarking: An International Journal, 19 (4/5), 2012 (co-authored)
“Boardroom Reform in Japanese Business: An Analysis of the Introduction of the Executive Officer System and its Effects”, Asian Business & Management, 3 (2), 2004