Chapter 1.3 Governance of Corporations: What Are Outside Directors For?

Join us in reading this book, The Only Way to Survive for Japan, subtitled "Corporate governance is sure to save our country." Although this book mainly focuses on corporate governance, it broadly covers outside contributors and governance as a whole. Peppered with real-life examples of successes and failures, the book is also a primer on the rules and cautions of corporate governance in Japan.

Find all published chapters at 'The Only Way to Survive for Japan'

Enjoy the third installment of Chapter 1:

Necessity of Reconsidering the Consultant System

There are some people who are hotly debating whether a consultant and advisor system should be employed. But I wonder if it is at all appropriate to incorporate two different professions into one system.

Except for someone who is called a special advisor, generally, it is often the case that a mere advisor has no authority to exert any influence on a newly-appointed president. On the other hand, a consultant can often have such power because a person who has once served as the top executive or held an equivalent position usually assumes the post of consultant after experiencing the position of chairman for some years.

I sometimes hear people critically allege that the consultant adversely affects the present top executive in his/her managerial judgments or that the consultant stands as a hindrance when a person who is well-experienced in management is appointed as an outside director. But at the same time the consultant is considered to be helpful if he/she functions well as an advisor to the present top executive on managerial matters.

Consultants and Advisors

In its 2017 Proxy Voting Guidelines, ISS, a leading American proxy advisory firm, basically recommended voting against the proposals of amendments to the Articles of Incorporation of companies which intend to add new provisions regarding the establishment of a consultant and advisor system in their Articles of Incorporation. This will be a good chance for further discussion on this matter. The circumstances of Toshiba will not allow the consultant system to remain ne’er-do-well. Toshiba once had as many as five consultants.

The reality of how the consultant is functioning varies from company to company, and, therefore, just abolishing the position is not a solution. But the authority and compensation that the consultant enjoys should be open to investors. Taking advantage of this occasion, it would be possible to include some provision regarding the consultant in the Articles of Incorporation thereby ensuring clear and complete disclosure of things around the consultant. The ingenuity of the scheme, however, should rest on each company.

But as consultants and advisors may serve concurrently as outside directors of other companies, it cannot be said that the consultant and advisor system will cause a shortage of candidates for outside directors. The new ISS Guidelines are expected to encourage each company to further consider the suitability of a consultant and advisor system.

(The Asahi Shimbun dated March 2017)

The CGS Guidelines

In an attempt to enhance medium and long-term corporate value, corporate governance reform is being accelerated. In May, the Ministry of Economy, Trade and Industry publicly released "the CGS Guidelines."

As part of Japan’s corporate governance reform, "the Corporate Governance Code," which was introduced for listed companies in 2015, carries significant weight. This was led by the Financial Services Agency. The CGS Guidelines, which are to supplement the Corporate Governance Code, compile concrete activities that are deemed practicable in order to boost "the power of earning" still further. The implementation of the recommendations in the Guidelines is not compulsory, but each company is required to take account of the provisions in the Guidelines and to consider how its management system should best serve the interests of the company.

What is worthy of note among others is a recommendation for how to make the body of outside directors function. The Guidelines state, "At least one of the outside directors should have relevant industry experience." The Guidelines also recommend people with industry experience "to consider positively accepting outside directorships of other companies."

Experience Helps

People who have appropriate industry experience are the most suitable to become outside directors. They are knowledgeable about business practices; and therefore, when problems arise, they are expected to make prompt and on-target judgments, addressing such problems properly. Furthermore, having been top executives themselves, they can give the present top executives practical advice based on their own industry experience.

Mr Yoshihiko Miyauchi, Senior Chairman of ORIX Corporation, became an outside director of Calbee, Inc in June 2017. He has the experiences of serving as both the president and chairman.

I hope that more people with managerial experience will assume the post of outside director in the future. Someday, it would be possible for an outside director to say to the top executive, “You’re fired!”

(The Asahi Shimbun dated May 2017)

Creation of Workable Auditing

The number of companies that have decided to set up an audit and supervisory committee (hereinafter, a company with an audit and supervisory committee (監査等会社: Kansatou Kaisha)) for the purpose of supervising management is about 800, accounting for more than 20% of all listed companies. Companies including Honda Motor Company, Ltd and Retail Partners Company, Ltd have transitioned from the hitherto company with a board of company auditors to a company with an audit and supervisory committee as of 2017, and it is likely that more and more companies will follow suit down the road.

But I doubt that just the formal structure of a company with an audit and supervisory committee will suffice to secure sufficient supervision over management. As an audit and supervisory committee is composed of a majority of outside directors, it is difficult for them to get hold of information inside the company necessary for performing satisfactory supervision over management. Information is expected to be obtained from the internal control division, but it is quite questionable whether such information will serve the purpose of the mission of the audit and supervisory committee members.

Significance in Substance

The duties of an audit and supervisory committee member are similar to those of an audit committee member of a company with a nominating committee, which are regarded as rather demanding. But Toshiba manifested the failure of this system. If it is just a transition for the sake of formality with no significance, I figure that a company with a board of company auditors would suffice or be better.

Unlike outside directors who are involved in resolutions of the board meeting, company auditors are regarded as able to act independently of any interest groups as they are fully committed to auditing. A part of the company auditors must be full-time; therefore, the workability of the board of auditors can be secured. I heard that a company with a board of company auditors hardly goes down well with foreign investors, but they may change their views if given a better and more convincing explanation.

Enhancing the Role of Auditors

There is a new movement going on to enhance the function of the board of auditors. The board of auditors of Kao Corporation has started evaluating the performance of auditing activities since 2016. All of the company auditors express their views, have discussions and make self-assessments, the conclusion of which is reported to the board of directors for disclosure.

Yet if a company is still serious about transitioning to a company with an audit and supervisory committee, it is inevitable to build up a workable scheme, by which audit and supervisory committee members who are also outside directors can get hold of the necessary information inside the company. If a company decides to employ a full-time audit and supervisory committee member who is also an inside director, it is essential to take measures to prevent it from going the way of Toshiba. If it is considered unfeasible, it would rather settle as a company with a board of company auditors.

(The Asahi Shimbun dated September 2017)

Provision of Information to Outside Directors

Japanese corporate scandals have surfaced one after another including the inspections by unqualified personnel of Nissan Motor Company, Ltd and of Subaru Corporation, and the data falsification by Kobe Steel, Ltd, by a subsidiary of Mitsubishi Materials Corporation and by a subsidiary of Toray Industries, Inc. Whenever a scandal occurs, the details are on the news, but no media agency dares to strike at the heart of the matter. Were their boards of directors functioning? Were their outside directors good for nothing? The media should confront the companies with such questions in an effort to get to the nitty-gritty of the occurrences.

A board of directors, which is an institution to supervise business operations and management, makes decisions regarding the development of the internal control system of a company. I figure that the occurrence and revelation of the scandals of such companies denote that their internal control systems had structural flaws.

Scandals are emergency circumstances. The board of directors should take matters into its own hands instead of leaving them in the hands of the president; when a scandal occurs, it has to take the initiative in investigating and establishing the cause, developing preventive measures and disclosing them. I am sure that this can only be done by a board of directors with outside directors.

Although I said it like that, it is difficult for outside directors to get hold of in-house company information.

Advantages of Inside Auditors and Outside Directors

In contrast, non-full-time outside company auditors basically have a strong ally in the full-time inside company auditors; at board meetings of auditors, they can get detailed information about the background of some occurrence from the full-time inside company auditors who are privy to the company’s circumstances. But there is no such support system for outside directors, and it is often the case that they have no way but only to draw on the given information.

In order for the outside directors to function well, it is inevitable for the company to set up such a system that enables the outside directors to obtain accurate and sufficient information. One idea is to set up an office of the board of directors, which I believe greatly helps when outside directors try to obtain information. There are some companies that already have such an office staffed with some personnel exclusively working for outside directors to obtain the necessary information.

Whether a company’s self-purification is activated or not under emergency circumstances depends on the proper functioning of such office of the board of directors, which should stand as the linchpin of providing information to outside directors. It is urgent to clarify the position of such office and enhance its workability. Just putting forth empty and purposeless measures will get us nowhere.

(The Asahi Shimbun dated December 2017)

What Are the Duties of an Outside Director?

Discussion is being propelled, again, over whether to make the election of outside directors compulsory.

As of July last year, 96.9% of the companies listed on the Tokyo Stock Exchange have at least one outside director. Therefore, some people argue that there is no need to revise the Companies Act in order to make the election of outside directors compulsory. On the other hand, there are some opinions supporting the proposal: by making it compulsory, the position of outside director becomes clear, which makes the outside directors more committed to their duties; overseas investors can have a clearer understanding of the system; it may become possible to attract more investment from overseas.

What needs to be focused on for deliberation is not the formality of making the election of outside directors compulsory, but the true picture of outside directors. How properly outside directors are functioning and how much their functioning is contributing to the enhancement of corporate value…what matters is their usability and serviceability. No matter how many outside directors are elected, it does not automatically serve to enhance corporate value. As a matter of fact, the scandals of Toshiba and Kobe Steel, Ltd. proved that their outside directors served little purpose. What is important is to deliberate on for whom outside directors work and what duties they must fulfill.

The Mizuho Case

From this point of view, Mizuho Financial Group, Inc. is worthy of note. In January, its nominating committee, which is composed only of outside directors, appointed Mr Tatsufumi Sakai, the present president of Mizuho Securities Co, Ltd, as the next president of the Group. Mr Yasuhiro Satō, the present president of the Group, stated:

The convention of the previous bank has already been eradicated. The nominating committee necessarily did not take account of the convention of the previous bank, and Mr Sakai was elected truly based on his competence and ability.

It was the first case in which the top executive was elected only by the outside directors. I hope that the precondition and arrangements that helped to make it happen will be revealed because his election seems to have something to do with the important basic policy on the part of the management: "We will seek further development revolving mainly around the securities business." (President Satō)

What are the duties of an outside director? Further discussion on this matter is desired.

(The Asahi Shimbun dated February 2018)

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