Opinion February 2012

Corporate Governance

MBAs can help stop the old-boys network

Corporate governance reform has been a hotly debated topic in Japan for more than 15 years. In 1997, Sony Corporation radically reformed its board of directors and replaced insiders with independent non-executives. But change in Japan has since come in fits and starts: legal reforms to allow firms to adopt a Western-style board with committees; changes in internal controls, modelled on the Sarbanes-Oxley Act of 2002; and the requirement that firms listed on the Tokyo Stock Exchange (TSE) have at least one independent director.

But in global corporate governance rankings, Japan remains at the very bottom, far behind the US, European nations and some other Asian countries. Today, only about half the TSE-listed firms have non-executive directors. Those that do, average only about two each and many of the directors are not independent but, rather, representatives of important clients or banks, or are retired government officials.

The Olympus scandal is all the more shocking because it occurred at a firm that, by Japanese standards, appeared to have relatively good governance. It looked better than average, having three non-executive directors who appeared to be independent. The firm was active and successful in global markets, and respected by investors worldwide. But perhaps the bombshell was that members of the board of corporate auditors (kansayaku) were intimately involved in the fraud.

Since that scandal broke, there have been increased calls for independent directors, and for this requirement to be made law should firms be unwilling to reform.

However, the difference would be minor were more non-executives added without a deeper reform of the system and attitudes.

In most firms, chief or other senior executives select the non-executive directors. Should they speak up, ruffle feathers or ask difficult questions, their terms of service will not be extended. Compensation for non-executive directors is significant, especially compared to corporate salaries in Japan. Thus, no matter how independent directors may appear, they are compromised if their position and income depend entirely on the chief executive and internal directors.

Furthermore, because non-executives are usually selected because they are known to the chief executive and other board members, they are likely to be members of the same networks—such as schools and golf clubs. Even if non-executives are independent, their function is highly constrained on most Japanese boards.

One of the most important responsibilities of a good board is appointing a chief executive with the right skills and vision. Non-executive directors are critical to ensuring this is based on objective criteria, and not politics and loyalty.

Typically, the president selects his successor, becomes chairman, and then retires to be an advisor. Thus, a president owes his position to his predecessor, and is entangled in ties of loyalty—not only to the chairman, but to several previous generations of top executives who are often still in the building and active behind the scenes.

This suggests the need for a nominations committee dominated by independent, non-executive directors. Only a tiny fraction of firms have adopted a system that mandates nomination, compensation and auditing committees dominated by non-executive directors.

For most firms, the idea that non-executives could determine the next chief executive is too shocking to even contemplate. But the Olympus scandal shows very clearly what can happen when bonds of loyalty among several generations of insiders become more important than shareholders, employees and the future of the firm.

Why has change been so slow and why has there been so much resistance? In part, there is still a myth—left over from Japan’s high-growth days—that Japan is unique, that business here follows its own rules, and that Western models do not apply. Those who resist non-executive directors tend to frame it in cultural terms—that outsiders who have not spent their career at a firm cannot understand its DNA and are not qualified to make, or advise on, important decisions.

Perhaps there is some truth in this. Japanese firms remain far behind their global counterparts in creating transparent and objective systems of talent development and succession planning. Corporate executives, in many cases, are behind their global counterparts in basic management literacy, understanding basic principles of strategy formulation, corporate finance and supply-chain management.

This makes it easy for executives to say that important decisions regarding leadership and strategy must be made based on intuition, and that strong networks are built as a result of employees being at the same firm throughout their careers.

For corporate governance to be truly effective, however, executives and non-executives must move away from these old-fashioned notions. Management education, through MBA and executive programmes, can provide executives with world-class management practices and a shared language of business and management, so that boardroom decisions are not based on intuition, loyalty, personal relationships and vague appeals to uniqueness.