Japan Inc. cannot stop at just giving seats to outside directors

The right agenda and mindset are also key for board success

Roland "Tiny" Rowland, the late British business tycoon famous for his failed attempt to take over Harrods department store in London in the 1980s, once compared independent board directors to "baubles on a Christmas tree" -- pretty to look at but useless.

Since the introduction of Japan's Corporate Governance Code in 2015, the country has been playing catch-up in modernizing its corporate boards, which have traditionally been dominated by in-house executives.

On the surface, progress has been impressive. As of last year, outside directors occupied 44% of the board seats of companies listed on the Tokyo Stock Exchange's Prime section, up from 28% in 2017, according to a data compiled by the Japan Association of Corporate Directors.

But without deeper scrutiny, investors can gain little besides "baubles" from nominal progress on corporate governance. A right-minded board agenda and open communication are vital, albeit often overlooked, ingredients too.

Granted, corporate governance via the oversight of a board representing outside stakeholders is no easy task anywhere. Despite official guidelines and regulations, high-profile governance failures are rampant across the globe.

Asymmetries between directors and management are at the crux of the universal challenge of ensuring board effectiveness. Fault lines divide executive and nonexecutive members on the board in terms of knowledge of the company's inner workings, resources and time, with executive members holding the upper hand in each case.

Even ignoring the overpowering, cultlike personalities of some CEOs -- an oft-cited culprit in governance breakdowns -- the diversity of nonexecutive directors' general skill sets can easily give way in the face of insiders' advantages.

Companies may seek to overcome this challenge by instilling the right tone in the operation of the board. This can take the tangible form of agenda-setting and ensuring an open culture for debate. If successful in addressing these matters, Japanese companies can gain an outsize advantage over peers.

First, the board agenda, which theoretically should be centered around important strategic decisions, must be calibrated at the optimum level of abstraction -- neither too operational to be caught in the weeds, nor so abstract that it becomes impossible to track progress.

This can present a unique challenge for Japanese companies. On the one hand, Japan Inc. suffers from the price of its success. Many successful Japanese companies, notably in the manufacturing sector, conventionally relied on organic momentum from collective ground-floor initiatives to win in the market and maintain operational excellence.

Management's job was simply to confirm the direction born and refined in the trenches. A top executive at a blue-chip Japanese manufacturing company proudly called this mechanism "middle-up and top-down" decision-making -- with an emphasis on the former. With memories of such successes, board agendas tend to be operational and granular, making it hard for nonexecutive directors to meaningfully contribute.

If not operational, board agendas can suffer from being at the other end of the spectrum: too abstract. In the view of a European executive with long experience in Japan, "Large Japanese companies often lack clear, measurable and understandable direction."

The strategic goals described by management are often lofty and too long-term. This works only when change is slow paced.

To raise the quality of discourse, management should start off by presenting well-defined strategic questions and corresponding sets of strategic alternatives to the board in a debatable format. Bernard Delmas, lead independent director of Nissan Motor, says that companies should present directors with a clear sense of management's strategic direction and include more operational and financial matters on board agendas.

Once the agenda is calibrated, then comes the question of culture -- are we up for constructive sparring? Given that most blue-chip Japanese company executives are lifetime employees, joining the board as an executive director means a step change in their definition of peers. No longer shielded by the company's cocoon of shared code language, they suddenly must communicate with nonexecutive directors about intricate issues the company faces.

Not only does this require a sophisticated level of verbal articulation, but executive directors must also embrace the virtue of objectivity brought by their new peers and overcome the natural skepticism arising from conditional asymmetry and the inevitable thought, "What could they possibly tell us that we don't know already?"?

Formal training can help turn this perspective around, but most Japanese companies rely on "on-the-job" training for new in-house directors who, left to their own devices, struggle to make the mental leap.

On the bright side, there are green shoots of corporate governance best practices in Japan. Hitachi, a heavy industry conglomerate known for its commendable recovery in the 2020s, has fully leveraged its board and its independent members, including heavyweight Western executives.

In a 2013 interview with Takashi Kawamura, then the company's CEO, George Buckley, then an independent member of Hitachi's board and a former CEO of 3M, compared how the two companies' boards worked.

While commending the Hitachi board as generally firm and unafraid to ask tough questions, Buckley politely pointed out that a key decision concerning the future of the company's power-generation business was brought to the board as "a fait accompli."

Buckley indicated he would have liked to have seen "a much longer period of discussion between the company and the board of directors before a decision was made" to allow room for board support to grow. He also commented on other key agenda issues, ranging from pushing innovation to globalizing human resources.

There is little doubt that Kawamura, who believed in the virtue of "looking outside in," took Buckley's mentoring to heart.

Corporate governance, if established the right way, can enhance enterprise value to the benefit of all stakeholders, as witnessed in Hitachi's case.

But there is a danger in overemphasizing structure over substance. Michael Coombs, a nonexecutive director of Godiva Japan and previously a senior executive at Shiseido and Coca-Cola, warns that while Japanese companies "love to talk about corporate governance, many tend to have a narrow and convenient interpretation."

Obsessing over key performance indicators of board diversity alone risks transforming independent directors into Rowland's Christmas baubles. While structure is important, the larger picture can be missed if it is overemphasized. To effectuate corporate governance, management and board directors must engage in constructive and open dialogue on the right agenda.

This article was originally published by Nikkei Asia on March 8, 2024.