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Toyota Debacle Spurs Reform Questions

by Michael W. Stocker and Professor Bruce Aronson
Directorship |
Toyota's recent woes may prove to offer some useful insight into long-running governance debates in the U.S.

Toyota's recent woes may prove to offer some useful insight into long-running governance debates in the U.S. The adoption of legislative and regulatory requirements for board independence in the U.S. was accompanied by a deeply divisive battle over the necessity for independent oversight of management, with opponents of board independence offering arguments similar to Toyota's defense of its own management philosophy. Toyota's current crisis is striking because it was compounded by a lack of internal corporate communications and timely responses-areas that are often thought to be a strength of insider-dominated boards. The consequences that Toyota has suffered as a result of its approach serves as a reminder of the need for U.S. corporations to ensure that directors serve as effective checks on management authority.

There is presently some diversity of corporate governance in Japan. While a small percentage of companies have adopted governance structures that would be familiar to Western investors, the traditional system of Japanese corporate governance, as exemplified by companies like Toyota, continues to dominate. This traditional approach differs significantly from current U.S. practices, as it is characterized by a belief that corporate policy-making is best left to executives who have hands-on familiarity with the company's operations. As a result, it is still quite common for Japanese corporations to have large boards consisting entirely of insiders without a single independent director. Virtually all of these directors are corporate managers who were promoted to director status and retain line-management responsibilities, and there is little distinction between the execution and supervision roles.

In keeping with this approach, the Japanese Companies Act does not require the presence of independent directors on corporate boards to monitor management. Instead, traditionally governed Japanese corporations rely internally on corporate auditors and externally on competition in product markets, team production alliances with suppliers, and "main banks" to monitor the performance of corporate management.

A "main bank" is both a large creditor and shareholder of the company, and is therefore in a position to intervene in corporate affairs if the company becomes troubled.

Because these creditor-directors are interested primarily in protecting the main bank's loans to the corporation, their interests are not always co-extensive with those of passive investors. In the past two decades, the corporate role of main banks has been on the wane.

The Japanese system reflects a different set of corporate goals than is typically found in the West. Japanese corporate governance is often characterized as a stakeholder system, in contrast to the shareholder system of the U.S. In Japan, corporations are primarily managed for stakeholders like employees, banks, suppliers, customers, and business partners. The role of management is not necessarily to increase the value of the shares and to benefit passive shareholders; rather, its critical task is to balance corporate obligations with the interests of all these stakeholders by allocating specific pieces of the corporate pie. Individual shareholders and institutional investors have traditionally been afforded a relatively low priority, although this has been changing to some extent due to ongoing reforms.

Reforms following in the wake of Japan's economic crisis of the 1990s resulted in significant changes in the law, but more modest changes in corporate governance practices. Recognizing the need to improve corporate governance, the Japanese government amended the prior Japanese Commercial Code in 2002, introducing the concept of outside directors and also allowing companies to choose between: (1) a U.S.-style board including nominating, audit and compensation committees which are to be composed primarily of outside directors; or (2) the traditional corporate auditor system under which no outside directors are required to be appointed.

This amendment sought to strengthen the governance of traditional corporations by requiring that half of the corporate auditors in large companies must be outsiders. Given Japan's tradition of insider-dominated boards, this was considered a significant reform. However, the corporate auditors are generally not independent of management, and are not required to have any special accounting or auditing qualifications. In addition, the potential of the new board committee system is weakened by a loose definition of outside director which only excludes individuals who are current or present directors, executives, or employees of the corporation or its subsidiaries. This would permit employees of other corporate affiliates or even family members of management to serve as nominal outside directors.

Only recently has the topic of the independence of outside directors been given serious attention in Japan, as the Tokyo Stock Exchange has begun to address this issue with respect to listed companies. In addition, a number of sophisticated companies that chose to adopt the "Western-style" board committee system, like Sony, have also voluntarily adopted the New York Stock Exchange's (NYSE) definition of independence.

U.S. standards for board independence, though imperfect, are considerably more rigorous. The current NYSE listing standards date to reforms enacted in 2003, in the aftermath of a series of huge corporate scandals in the first years of this century. These standards require that a supermajority of a listed company's board be independent.

More importantly, the NYSE rules require that not only current, but also prior, relationships be considered in assessing the independence of directors. Under the NYSE listing standards, no director qualifies as "independent" unless the board of directors affirmatively determines that the director has "no material relationship" with the listed company, either directly or as a partner, shareholder or officer of an organization that has a relationship with the company. In their annual proxy statements, companies are required to disclose these determinations and the basis for a determination that a relationship is not material.

The definition of "independence" under the NYSE rules is relatively restrictive. For example, a former employee of the listed company or a former affiliate or employee of the listed company's present or former auditor cannot be deemed independent until at least three years after such relationship terminated. A director may not be deemed independent if he is employed, or has been employed in the last three years, by a company in which an executive officer of the listed company serves as a member of the board of director's compensation committee.