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Fmancial Economics 36 (1994) 225-258
~~~,~~~~~ts
of outsiders to Japanese boards
B
Dererminants and implications
for managers
Steven 1% Kaplan**“, Bernadette A. Mintonb
‘Graduate School” of Business, University of Chicago, Chicago, IL 60637, USA
bOhio State University, Columbus, OH 43210, USA
(Received March 1993; final version received February 1994)
Abstract
This paper investigates the determinants of appointments of outsiders - directors
previously employed by banks (bank directors) or by other nonfinancial firms (corporate
directors) - to the boards of large nonfinancial Japanese corporations. Such appointments increase with poor stock performance; those of bank directors also increase Jslith
earnings losses. Turnover of incumbent top executives increases substantially in the year
of both types of outside appointments. We perform a similar analysis for outside
appointments in large U.S. firms and find different patterns. We conclude that banks and
corporate shareholders play an important monitoring and disciplinary role in Japan.
Key words: Corporate governance; Boards of directors; Relationship investing
JEL classification: G32; G21; D23
* Corresponding autS;or.
Etsuko Hashimoto, Rochelle Kopp, Naoki Shigetake, Keiko Tanaka, Mari Tanigawa, and Yaz
Tanigawa provided able research assistance. We have received helpful comments from Charles
Calomiris, Eugene Fama, AniI Kashyap, Wayne Mikkeison (the editor), Kevin M. Murphy, Megan
Partch (the referee), Robert Vishny, Michael Weisbach, Luigi Zingales, and seminar participants at
the CEPR/ESF Workshop in Corporate Finance, Columbia University, the Federal Reserve Bank
of Richmond, Harvard Business School, Hong Kong University of Science and Technology,
Michigan State, the University of Chicago, the University of Michigan, Washington University, and
Yale Law School. The first author acknowledges research support from the Wilham Ladany Faculty
Research Fund, the Lynde and Harry Bradley Foundation, the Qlin Foundation, and the Center for
Research in Security Prices. Previous versions of this paper were titled: ‘Outside’ Intervention in
Jap,?nese Companies: Its Determinants and Its Implications for Managers.
0304-405X,94/$07.00 0
SSDI 0304405x9400781
1994 Elsevier Science S.A. All rights reserved
u
226
S.N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
1. Introduction
In contrast to market-oriented corporate governance in the U.S., corporate
governance
in Japan is generally characterized as a stable, relationship-based
system. A company’s relationships with its main bank, corporate shareholders,
and corporate group supposedly play important roles in governance.’ Takeovers, proxy fights, and public contests for control are rare. Although the
existence of the three types of relationships in Japan is well-documented, the
impact on managers is less so. Some have argued that these relationships reduce
agency costs, discipline managers, and substitute for an external market for
corporate control.2 Others believe that these relationships both entrench managers and serve as a form of insurance against liquidation. Because shareholdings are stable and boards are dominated by insiders, it is very difficult to oust
incumbent management. In the event a company encounters financial difficulties, the relationships help ensure the company’s survival whether or not it is
efficient to do SO.~Between these two extreme views is the intermediate view that
Japanese managers must earn enough to satisfy their banks and meet debt
payments. Conditional on earning a satisfactory profit, however, managers can
run their firms in the interests of employees or themselves.4 All of these views are
based largely on anecdotal or indirect evidence.
In this paper, we attempt to distinguish between these views by studying the
determinants and implications for managers of appointments of outsiders - individuals previously employed by banks (bank directors) or other nonfinancial
corporations (corporate directors) - to the boards of large, nonfinancial
Japanese corporations from 1980 to 1988. Based on a large body of case
evidence, we use such appointments as indicators that the main bank or
nonfinancial corporation is paying particular attention to the governance of the
appointing company.
We find that appointments of both bank and corporate directors increase
significantly with poor stock performance; appointments of bank directors
increase with earnings losses as well. Appointments of outsrLers also increase
with measures of the intensity of the relationships said to govern Japanese
companies: appointments of bank directors increase in firms with larger borrowings from banks; appointments of corporate directors increase in firms with
more concentrated shareholders and in firms affiliated with a corporate group.
To test for differences in the governance roles of such outsiders in the two
countries, we compare the Japanese results to those for large, nonfinancial U.S.
‘See Aoki (1990) and Aoki, Patrick, and Sheard (1994).
2See Grundfest
(1990), Hoshi et al. ( 1990, 1991), Porter (1992), and Prowse (1990).
3See Abegglen and Stalk (1983, Blinder (1992), Coffee (1991), and Nakatani
4See Aoki ( 1990) and Kester ( 1991).
(1984).
S.N. Kaplan, B.A. Mintort,Liournal of Financial Economics 36 (1994) 225-258
227
outside directors in U.S.
corporations are generally less sensitive to stock and earnings performance than
are outside appointments in Japanese companies. While appointments of directors affiliated with large blockholders are roughly as sensitive to corporate
performance in U.S. companies as outside appointments are in Japanese companies, they are less frequent, occurring less than 20% as often as outside
appointments in Japan.
These initial results are consistent with governance relationships in Japan
playing a monitoring and disciplinary role. They are also consistent, however,
with an insurance interpretation in which the presence of an outsider signals to
suppliers, customers, or others that the bank or the affiliated corporation will
support - i.e., bail out and, therefore, insure - the appointing company. We
distinguish between the two interpretations by considering the relation between
outside director appointments and top executive turnover. Turnover increases
substantially in periods when outsiders are appointed, even when we control for
company perform,nce. We conclude that banks and corporate shareholders
play an important monitoring and disciplinary role in Japan.
Two additional pieces of evidence support this interpretation. First, we
examine the relation of top executive turnover to outside and blockholder
appointments in large U.S. corporations. Top executive turnover in the 1J.S. is
insensitive to outside appointments, which indicates that appointments offoutside directors play a different role in the U.S. than they do in Japan. Appointments of directors affiliated with blockholders are, in contrast, associated with
modestly increased top executive turnover (as well as poor company performance). Such blockholder appointments, when they occur, may play a similar
role to outside appointments in Japan. However, the relative infrequency of
blockholder appointments in the U.S. suggests they play an appreciably smaller
governance role’than do outside appointments in Japan.
Second, we examine company performance in Japan around the years of
outside appointmeirts. The monitoring or disciplining interpretation predicts
that managers of poorly performing companies will be replaced by managers
who will reverse the poor performance. We find that bank directors are appointed in companies that are contracting or financially distressed, while corporate directors are appointed in companies that have temporary problems.
Company performance stabilizes and improves modestly after both types of
appointments.
Overall, we interpret our results as favoring the view that the set of bank and
intercorporate relationships in Japan plays a monitoring and disciplinary role.
In this sense, the relationships may act as a substitute for the more market-oriented U.S. control mechanisms. Because outside appointments are driven
most strongly by poor stock performance, our results do not support the
intermediate view that managers can xun their companies in the interests of
employees or themselves as long as they earn a satisfactory profit.
228
S.N. Kaplan, B.A. Min ton/ Journal of Financial Economics 36 ( 1994) 225-258
Our results support a monitoring role for banks and other corporations.
However, the primary importance of stock returns and current income in
outside appointments sharply contradicts the view of Porter (1992), among
others, that the corporate governance system in Japan pays little, if any attention to current stock prices and other measures of ‘short-term’ performance.
Recently, Woshi? Kashyap, and Scharfstein (1993) and Kester (1991) have
argued that financial market deregulation and operating successes in the 1980s
weakened the governance relationships in Japan. We conclude the paper by
testing for a deterioration in the sensitivity of bank and corporate appointments
over time. We do not find such a deterioration.
The paper proceeds as follows. Section 2 describes the sample selection,
companies, and data sources. Section 3 examines the performance-related determinants of outside appointments. Section 4 adds relationship-based explanatory
variables. Section 5 measures top executive turnover in firms that make outside
appointments. Section 0 presents evidence on pre- and post-appointment financial performance. Section 7 considers changes in relations between appointments and performance over time. Section 8 concludes.
2. Sample and variable description
2. I. Sample and data sources
The sample of Japanese companies includes the 119 publicly traded Japanese
industrial corporations on Fortune Magazine’s List of the 5cO Largest Foreign
Industrials by Sales in 1981. Because the fiscal years of most Japanese companies end in March, the Fortune list is largely based on fiscal years ended
March 1980.
Financial data on the Japanese companies come from several sources. Financial statement, employment, and stock price data come from annual issues of
Diamond’s Kaisha Yoran Zenjojo Kaishabarr and the Daiwa Institute of Research Analysts’ Guide. Data on shareholdings, borrowings, corporate executives, and directors are obtained from editions of Kigyo Keiretsu Soran and from
the 1982 and 1984 Yuka Shoken Hokokusho (the Japanese equivalent of U.S.
10-K filings). Additional data on corporate executives and directors are obtained from annual issues of Diamond’s Kaisha Shokuin Roku (Diamond’s
Company Personnel).
3anel A of Table 1 presents data on equity market value, sales, and current or
pre-tax income in 1980 and 1988 for the 119 Japanese firms. The panel indicates
that sales and equity market values for the sample firms increased substantially
in dollar terms over the sample period. These increases were driven by the
appreciation of the yen and the rise in the Japanese stock market. The sales and
equity values are presented in dollars for the benefit of U.S. readers. In the
S. N. Kaplan, B.A. Min ton/ Journal of Financial Economic: 36 ( 1994) 225-258
229
regressions, the performance variables are measured in yen. Consistent with
most previous work on Japanese companies, the accounting measures (here and
throughout the paper) come from unconsolidated financial reports. We obtain
similar results using consolidated financial data for the subset of firms for which
we have such data.
The sample of U.S. companies includes the 146 publicly traded industrial
firms among Fortune Magazine’s 1981 list of the 150 industrial companies with
the highest sales. The Fortune list is largely based on fiscal years ended December 1980. Financial data on the U.S. companies come from COMPUSTAT;
stock return data from the CRSP tapes. Data on corporate executives and
directors are obtained from proxy statements, 10-K filings, and issues of
Moody’s industrial Manuals. Because Moody ‘s publication deadline is mid-July,
we measure turnover from July 1 to June 30. To synchronize with the Fortune
list, we begin the sample with the 1981 edition and record the relevant data on
all board members through the 1989 edition. The sample, therefore, begins iv
fiscal year 1980 and ends in fiscal year 1988. We used firm proxy statements to
confirm executive and director appointment dates.
As reported in Table 1, the U.S. firms are larger than their Japanese counterparts. In 1980, the U.S. firms have median sales of $4.9 billion versus $1.6 billion
for the Japanese firms. The gap narrows by 1988 when the U.S. firms have
roughly twice the sales of the Japanese firms. The true differences in sales are
actually smaller, because the Japanese sales measures are for parent operations
only. Consolidated sales would be higher.
2.2. Governance measures
2.2. I. Japan
As in the U.S., boards of directors in Japan are legally responsible for
managing the corporation. 5 The directors are elected at a shareholder meeting
to terms of not more than, and usually equal to, two years. Shareholder meetings
are held annually, but shareholders holding at least 3% of a company’s shares
have the right to convene a meeting to vote on the dismissal of directors.
Qur sample firms have a median of 21 directors. The most important director
is typically the president. He is considered the chief executive officer., although,
in some cases, the chairman has greater power. Most companies give three or
four directors, always including the president, the right to represent the company in dealings with third parties and to make decisions on matters delegated
by the board. These directors are a company’s representative directors. If the
chairman is powerful, e.g., Sony’s Akio Morita, he will have representative
‘The discussion in this section is taken largely from Heftel(l983).
and Gorlach (1993).
See also Ballon and Tomita (1988)
691
6,638
2,40 1
5,649
0.054
0.043
0.285
0.141
0.396
0.647
0.168
Sales in fiscal year 1980 ($ M)
Sales in fiscal year 1988 ($ M)
Current or pre-tax income to assets 1980
Current or pre-tax income to assets 1988
Debt to total assets 1980
Debt of top lender to total debt 1980
Fraction of shares owned by top 10 shareholders 1980
Member of financial group (Dodwell 1982)
Member of enterprise group (Dodwell 1982)
Mean
0.368
0.307
0.132
0.047
0.039
1,580
3,456
449
3,703
Median
0.119
0.180
0.069
0.032
0.044
2,464
6,845
733
7,604
Std. dev.
0.125
0.090
8,556
11,988
3,852
7,652
Mean
U.S. firms
____
-___---
- -----
___--
Japanese firms
Market value of equity 1980 ($ M)
Market value of equity 1988 ($ M)
(A) Levels
_
--_-___
~___-_____
0.126
0.093
4,85 1
7,065
2,022
4,447
IvIedian
_I__--
--
0.089
0.070
12,313
17,017
5,673
10,265
Std. dev.
-.______
Summary statistics for firm financial and governance characteristics for 119 large Japanese firms and 146 large U.S. firms. Japanese companies are listed in
Fortune Muyuzine’s 1981 list of the largest international companies (by sales). U.S. companies are among the 150 largest companies (by sales) in Fortune
Maguzine’s 1981 list of the largest industrial companies in the U.S. U.S. stock returns are total calendar year returns. Japanese stock returns are fiscal year stock
returns not including dividends. Dividends would increase returns by approximately 1.25% per year. Sales growth is the annual change in (log) sales. Change in
pre-tax income to assets is the annual change in the ratio of pre-tax income to total assets. Yet values are converted into dollars using year-end yen-dollar
exchange rates. Representative directors are directors with representative rights. Japanese data are from DiamonZr Kaisha Yoran Zenjojo Kaishatm, the Daiwa
Institute of Research Analysts’ Guide, Kigyo Keiretsu Soran, and the 1982 and 1984 Yuka Shoken Hokokusho. U.S. data are from COMPUSTAT, proxy
statements, 10-K filings, and Moody’s Industrial Manuals.
Summary statistics for financial and governance characteristics of Japanese and U.S. firms
Table 1
Q
2
3
I
G
2
;
ti
3r
\2
2
2
‘2
k
3’
s
*
4
$”
&
L
_. ---__
At least one new outside director appointed (per firm-year)
Percentage of new outside directors appointed (per firm-year)
At least one new blockholder director appointed (per firm-year)
-
At least one new director appointed with bank experience (per firm-year)
At least one new director appointed with other nonfinancial corporation
experience (per firm-year)
At least one new director appointed with bank or other nonfinancial
corporation experience (per firm-year)
Stock returns
Sales growth
Change in pre-tax income to assets
Pre-tax income is negative (per firm-year)
(B) Panel data, one-year periods, 1980-1988
- 0.000
- 0.000
0.088
0.129
0.059
0.075
0.122
0.036
0.150
0.032
0.12
0.02
0.26
0.515
0.089
0.023
- 0.033
0.005
0.115
0.122
- 0.050
0.001
0.133
0.16
0.07
0.26
-
$z
232
S. N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (I 994) 225-258
rights, The median number of representative directors in our sample firms is
three (the average is 4.22). Very few of the directors in Japan are outside
directors as we know them in the U.S. At the start of fiscal year 1981, all of the
directors of the median firm in our sample are currently employed by the firm. In
fact, the sample firms have a median of only two directors who have ever worked
for another firm.
In this paper, we study board appointments of those few directors with
previous experience at another firm. We refer to such directors as ‘outsiders’. We
distinguish between previous employment at a bank or at a different Japanese
corporation, referring to directors with bank experience as bank directors, and
to those with corporate experience as corporate directors. Our use of the term
outsider follows Aoki, Patrick, and Sheard (1994) who describe the board of
directors as largely composed of two kinds of incumbent managers: ‘insiders or
so-called lifetime employees who have risen to top management positions
through internal promotion hierarchies and outsiders, ex-employees of other
organizations (such as banks, affiliated companies, or government ministries)
who have entered the firm usually at board level’ (p. 15).
We focus on appointments of outsiders because they are unusual, and are
generally considered an indication that the main bank or outside corporation is
paying particular attention to the governance of the appointing firm. Aoki
(1990),Aoki et al. (1994),Hoshi et al. (1990 and 1991),and Sheard (1994) provide
anecdotal and case evidence of such attention.
We follow the boards of directors of our sample Japanese companies from
1980 to 1988. An outside appointment is defined as an appointment of
one or more outsiders to a board in a given year. Panel B of Table 1 indicates
that firms appoint at least one bank director in 7.5% (or 70) of firm-years,
at least one corporate director in 5.9% (or 55) of firm-years, and at least
one of either in 12.9?6 (or 120) of firm-years. We do not distinguish between
single and multiple appointments because in most appointment-years 90% for bank and 83% for corporate appointments - only one outsider is
appointed. Bank and corporate appointments, therefore, are unusual, but not
rare. (We note that because firms appoint an average of three new directors each
year, bank and corporate directors make up only slightly more than 5% of all
director appointments in the sample. Another 1.8% are previous government
employees, with at least one government director being appointed in 5.5% of
firm-years.)
Over 90% of the outside directors joined the sample firms in the same year
they were appointed directors. Based on Aoki et al. (1994) and private conversations with bankers, we consider the few directors with prior experience at the
appointing firms to be outsiders. Our results are qualitatively identical when we
do not consider them outsiders. Among the outside directors, 72% of bank
directors and 49% of corporate directors are described only as employees of the
sample firm. The remaining outside directors retain a concurrent affiliation - as
S.N. Kaplan, B.A. MintonlJournal of Financial Econonlics 36 (1994) 225-258
233
either a director or employee - with their previous firm. In what follows, we
make no distinction between those with and without a concurrent affiliation.
Our results are qualitatively similar when we consider directors with concurrent
affiliations separately fro,m those without such affliations.
In 45% of bank appointments and 37% of corporate appointments, the new
outsider appears to replace an outside incumbent. Our results are qualitatively
similar for replacement and nonreplacement appointments, and, therefore, we
do not distinguish between them in our analysis. Once appointed to the board,
the outside appointments serve what appear to be normal directors’ terms. The
average terms as director for bank and corporate directors (for whom we have
completed terms) are respectively, 8.2 and 8.4 years, similar to the 8.3.year
average term (12.1% annual turnover) for all directors.
The outside directors tend to go in at the level of director, rather than at the
more senior level of representative director. While an outsider is appointed to
the board in 12.9% of firm-years, an outsider is appointed a representative
director in only 2.6% of firm-years. This indicates that it is unusual for outsiders
to explicitly take over the management of the firm.
Our definition of directors does not include appointments of statutory auditors. All Japanese firms hire one to three statutory auditors who are generally
retired employees of the firm, the main bank, or some other firm. The auditors
can attend, but cannot vote at, board meetings. Merck and Nakamura (1993)
also estimate the determinants of bank appointments and include statutory
auditor appointments as director appointments. They note, however, that they
obtain similar results when auditors are excluded.
We also exclude board appointments of government officials and nonJapanese directors. When government officials retire in Japan, they occasionally
obtain board positions in firms they previously regulated. This is known as
a ‘descent from heaven’. Because such appointments are generally considered
rewards, we do not consider them as outside appointments. Similarly, we
exclude board appointments of non-Japanese directors because they are unlikely to be part of the Japanese corporate governance system.
2.2.2 United States
We consider two types of outside apoointments in the U.S. First, we consider
new appointments of outside directors - directors who are neither current or
former executives of the compan 1~. While not identical to the definition of
Japanese outsiders, this definition identifies directors who come from outside
the firm. The U.S. firms have a median of 15 directors, ten of whom are outside
directors. We measure appointments of outside directors in two ways. First, we
create a dummy variable equal to one if a firm appoints at least one new outside
directcr. Because such appointments are so common, occurring in 51S% of
firm-years, we also measure appointments of outside directors as a fraction of
initial outside directors to gauge the magnitude or intensrty of appointments of
234
S.N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
new outside directors. We refer to this variable as the percentage of outside
appointments. The percentage of outside appointments averages 0.089 or 8.9%
per firm-year.
pointments
The second type of outside appointment we consider is boar
ore of the company’s stock. We
of individuals affiliated with holders of 5%
e use a dummy variable equal to
refer to these as blockholder appointments.
one if such an appointment occurs, and zero otherwise. Blockholder appointments occur in only 2.3% of firm-years, significantly less often than outside
appointments in Japan. We believe that blockholder appointments in the U.S.
correspond most closely to bank and corporate appointments in Japan, because
the main bank and other corporate shareholders typically own nontrivial equity
stakes in the appointing firms. In our Japanese sample, the main bank holds an
ownership stake of at least 3% in almost 75% of the firms; and the largest
stockholding by a corporate shareholder is at least 5% in more than 90% of the
firms.
2.3. Performance measures
We measure firm performance in the year of the director appointment and the
two previous years. We use four measures of performance: (1) company stock
returns, (2) sales growth, (3) change in pre-tax income as a fraction of total assets,
and (4) a dummy variable equal to one if pre-tax income is negative. The dummy
variable for negative pre-tax income indicates that a firm’s accounting earnings
are less than its accounting operating and financial expenses. Throughout the
paper, we interpret negative pre-tax income as an indicator of firms that are
having difficulty meeting their financial obligations. Panel B of Table 1 presents
summary statistics for the performance variables for the Japanese and U.S.
firms.
2.4. Relationship measures
In addition to considering the association between performance and appointments, we also consider variables that measure the strength of the three types of
relationships said to govern Japanese 6rms.
We measure the strength of bank relationships in two ways. First, we use the
ratio of bank borrowings to total assets in 1980, the year before our analysis
begins. The median value of bank borrowings to total assets is 0.307. We
measure debt levels at the beginning of our sample period to reduce the
likelihood that performance - particularly earnings performance - determines
debt levels.
Second, we follow oshi, Kashyap, and Scharfstein (1990) and estimate the
strength of a firm’s relationship with its main bank as the fraction of a firm’s
borrowing that is provided by its largest lender. Over 75% of the bank directors
in our sample were previously employed by the appointin
st lender.
The median sample firm obtains 0.132 of its total borrowings from its E
lender. The variable is set to zero for firms with no borrowings.
As a measure of the importance of large intercorporate shareholders, we
obtain the ownership concentration of the top ten shareholders in 1980.
large shareholders in Japan are corporate shareholders.
Finally, we measure group relationships. There are tws types of groups
in Japan: financial keiretsu or financial group firms that are linked by relationships to a main bank, by cross-holdings of equity, and by product-market
links; and enterprise group firms that are organized around a particular
enterprise and linked by cross-holdings of equity and stronger product -market
links.
We consider a firm to be a member of a financial group if Do
associates the firm with one of the six financial groups: DKB, Fuyo
Mitsui, Sanwa, and Sumitomo. Almost 65% of our sample firms have an
association with one of these financial groups. We obtain qualitatively similar
results when we use two different definitions for financial group membership: (1)
members of any of the president’s councils associate with the six financial
groups or (2) firms listed by Dodwell as being strongly inclined to one of the
financial groups.
We also use Dodwell (1982) to determine whether a firm was associated with
one of six large enterprise groups in Japan: Hitachi, Matsushita, Nippon Steel,
Nissan Motors, Toshiba, and Toyota. Almost 17% of our sample firms are
associated with one of these enterprise groups.
Summary statistics for all five relationship variables are presented in panel
A of Table 1.
3. Outside appointments and performance
3.1. Outside appointments in Japan
Panel A of Table 2 presents maximum likelihood logit regression estimates of
the likelihood of an outside appointment - eiiher from a bank or another
corporation - as a function of performance. Separate estimations are run for
each of the four performance measures. [To make sure that outliers do not drive
the results, we also transformed the continuous performance variables into their
decile ranks. We obtained results qualitatively similar to those presented in what
follows.) The regressions also include time-period dummy variables which are
intended to control for economy- or market-wide shocks that vary over time.
(The regressions do not report the time-period coefficients,) The results are
qualitatively and statistically similar when the time-period variables are excluded. The tab!e also presents the sensitivities of the likelihood of an outside
of outside directors
versus performal,ie
in Japan
Logit
0.22
- 0.79
0.05
-_-
Sales growth
Sitme period
One lag
TB~ lags
-----
- 0.58
-- 1.37
0.05
variables
Stock ret urn
Same period
One lag
Two lags
Indeppndent
- 0.059
- 0.140”
0.00~1
Slope
0.023
- 0.083
0.005
Model p = 0.87
CO.981
co.933
co.991
Model p = 0.01”
[0.44-J
co.441
co.451
[S.E.]
(A) Bank or nonfinancial
corporation
- 0.45
- 0.58
- 0.35
- 0.01
- 1.48
0.30
Logit
(B) Bank
- 0.029
- 0.037
- 0.023
Model p = 0.18
Cl.241
Cl.181
[ 1.243
0.37
- 1.52
0.89
- 1.39
- 0.34
- 0.091”
0.019
[0.56-J
[0.52]
Model p = 0.06’
- 1.59
Logit
- 0.001
Slope
co.53J
[S.E.]
____~__
- 0.067b
0.059b
- 0.014
Model p = 0.69
Cl.381
Cl.311
[ 1.407
0.017
- 0.069
0.04 1
Model p = 0.01”
CO.613
COW
[0.66-J
-____
Slope
corporation
[S.E.)
(C) Nonfinancial
Logit regression estimates that at least one new director previously employed by
Logi. regressions of the likelihood that a new director was previously employed by (A) a bank or a different nonfinancial corporation, (B) a bank and (C)
a diflzenl nonfinancial corporation as a function of stock return?, sales growth, earnings growth, and negative pre-tax income for 119 Japanese firms from
NXCt%31QllX. Separate regressions are run for each performance measure (current and lagged values). All regressions include dummy variables for the time
pt’r:od. S!ope measures the change in the probability of an appointment to a change in the independent variable irilplied by the logit coefficienrs evaluated
at sample mear;^,. Model p-value reports the joint significance level of the current and lagged coefkients
of the performance variable.
_______.
-__--__. - -
Regression estimates of the likelihood of appointments
2
5
3
I
z
X
cSipnifk~~ntly
a Significantly
bSipniticantly
vrtriable
0.73
0.32
- 5.92
1.73
0.12
933
933
Model p = 0.01 b
CO.381
co.393
0.079b
0.050’
- 0.101
0.563
0.304
Model p = 0.45
[6.66]
[6.07]
C6.43)
0.075
0.92
0.64
- 1.57
8.80
4.70
0.129
Model p = 0.02b
CO.321
ro.341
o.095b
0.037
- 0.626
0.183
0.013
Model p = 0.66
[5.16-J
[4.8 I]
[SS 1-J
different from zero at the 1% level .
different from zero at the 5% level.
different from zero at the BO% level.
Mean dependent
Pre-tax incomt is negative
Same period
One lag
Same period
01;; klg
Two lags
Change in prc-1 ax income, assets
-
0.20
- 0.35
4.78
- 11.41
- 9.19
- 0.512
- 0.412
933
0.059
IModel p = Q.92
co.531
[0.58-J
0.013
- 0.014
[7.23]
- 0.214
Model p = 0.25
[6.98]’
[6.67]
-
k
3N.
s
-?
k
2
;c
*
F
ia
a
238
S.N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
appointment to a unit change in the performance variables implied by the logit
coefficients. These sensitivities are labeled ‘slopes’, and are economically equivalent to the coeficient estimates that would be obtained in an ordinary least
squares regression. The discussion below focuses on these slope estimates.
Panel A indicates that outside appointments are most closely related to stock
performance and negative current income. A two-standard-deviation
drop in
stock returns (52%) is associated with 3.10/o and 7.3% increases, respectively, in
the likelihood of an outside appointment in the same and following year. The
cumulative 10.4% increase (significant at 1%) is economically and statistically
large compared to the overall likelihood of 12.9%. Similarly, negative income is
associated with an increased likelihood of an outside appointment in the same
and following year, for a total increase of 13.2% (significant at 2%).
It is important to note that outside appointments are most sensitive to current
measures of performance - earnings and stock returns. Sales growth, which
some would consider a proxy for market share and a firm’s long-term health, has
no explanatory power.
3.1.2. Bank appointments
Panel B of Table 2 presents logit estimates of the likelihood of bank director
appointments. The likelihood of a new bank director is most closely associated
with negative pre-tax income. The estimates imply that the likelihood of a new
bank director increases by 7.9% in the year of negative income and by 5.0% in
the subsequent year, for a cumulative increase of 12.9% (significant at 1%). This
result indicates that bank appointments respond relatively quickly to measures
of recent performance. Furthermore, the increased likelihoods are both large
relative to the unconditional likelihoods of 7.5%.
There is also a negative relation betwee the likelihood of a bank director
appointment and stock returns. A two-standard-deviation
decline in stock
returns is associated with a 4.7% increase in the likelihood of a bank appointment in the following year (significant at lo/,). This is also a large increase
relative to the unconditional likelihood of 7.5%.
3. I .3. Corporate appointments
Panel C of Table 2 reports logit estimates of the likelihood of appointments of
new corporate directors. Such appointments are most closely associated with
poor stock performance. The estimates associate a two-standard-deviation
decline in stock returns with an increased likelihood of a corporate director of
3.5% in the current year and 3.19/o in the next year. This 6.6% cumulative
increased likelihood is economically significant relative to the unconditional
likelihood of 5.9%. Corporate appointments are also related to changes in
pre-tax income. The coefficient on the contemporaneous earnings change, as
well as the sum of the three coefficients, are significant at the POoh level. (The
sum of the coefficients is sign+I,,ant at the 10% Eevcl while the model p-value
S. N. Kaplan, B.A. Minton/ Journal of Financial Ecmomics 36 (I 994) 225-258
239
presented in Table 2 is not. The model p-value tests if and canGot reject that the
three coefficients are jointly equal to zero.) Strikingly, corporate appointments
are not related to negative income.
The patterns for outside appointments suggest that bank and corporate
appointments occur under different circumstances. Bank appointments are most
likely in firms with poor stock performance and difficulty meeting their financial
obligations. Corporate appointments, in contrast, are most likely in firms with
poor stock performance that is unrelated to an inability to meet financial
obligations.
We estimated a bivariate probit model to test whether one type of appointment affects the likelihood of the other, conditional on performance (as measured by stock returns and negative current income). We find that bank and
corporate appointments are negatively, but not significantly related. This suggests that the appointment of one type of outsider does not have an appreciable
effect on the decision to appoint the other type of outsider.
3.2. Comparison to United States
Table 3 reports regression estimates of the likelihood of outside appointments
and blockholder director appointments in U.S. firms. The regressions of new
outside appointments and blockholder appointments are estimated using a logit
specification, while those of the fraction of new outside directors appointed are
estimated using ordinary least squares. Table 3 also reports p-values (labelled
p-value Japan vs. U.S.) for differences between the coefficient estimates in the
:rnnese logit regressions for
U.S. logit regressions and the coeficients in the Ja,,,
bank or corporate appointments in panel A of Table 2. The p-values are negative
when the coefficients are smaller in Japan than in the U.S. The p-value for the
Joint test that all coefficients are zero is reported below the p-values for
individual coefficients.
Panel A of Table 3 indicates that the likelihood of at least one outside
appointment in the U.S. is significantly related only to contemporaneous negative income, with the coefficient implying an increased likelihood of 10.70//o
(significant at 10%) relative tc the sample likelihood of 51.5%. The likelihood of
at least one outside appointment is not significantly related to stock performance. Furthermore, the stock return coefficients differ significantly (at the 10%
level) from those in the Japanese regressions. Therefore, outside appointments in
the U.S. are not as sensitive: to poor performance as in Japan
In panel B, appointments of new outside directors as a percentage of initial
outside directors in the U.S. are significantly related to current-period stock
returns and negative income, as well as to sales growth lagged two years. [The
results for stock returns and earnings changes are consistent with Hermalin and
Weisbach (1988) who find that the number of new board appointments is
negatively related to (industry-adjusted) stock returns, but not to earnings
Logit
- 0.04
- 0.29
0.24
Independent
variables
Stock return
Same period
One lag
Two lags
-- 0.010
- 0.072
0.060
Slop
Model p = 0.57
CO.281
CO.271
co.251
[S.E.]
(A) At least one new outside director
-___
U.S.
0.08’
- 0.16
- o.04b
0.63
vs.
p-value
Japan
CO.01
6)
IO.016)
[0.015]
[S.E.J
Model p = 0.14
- 0.028’
- 0.023
0.005
OLS
(B) New outside directors
(as fraction of ail
outside directors)
--
- 0.63
- 1.22
- 1.33
Logit
- 0.012
- 0.023b
- 0.025b
Slope
Model p = 0.07”
CO.721
co.711
CO.721
[S.E.]
0.38
0.92
- 0.82
O.G7’
p-value
Japan
vs. U.S.
(C) At least one new director affiliated with 5%
blockholder
Regression estimates of (A) the likelihood of an outside director appointment, (B) the fractional turnover of outside directors, and (C) the likelihood that a new
director is affiliated with a 5% biockhoiCer by one-year periods for 146 US. firms as a function of sales growth, stock returns, earnings growth, and negative
pre-tax income from 1980 to 1988. Panels A and C preb,t-nt loeit
_ c regression estimates and standard errors. Slope measures the change in the probability of an
appointment to is change in the independent variable implied by the iogit coeficients evaluated at sample means. Panel B reports coefficients and standard errors
from OLS regressions. In ail panels, a separate regression is run for each performance measure. Ail regressions include dummy variables for the time period.
Model p-value reports the joint significance level for the current and lagged values of the performance variable. The p-value Japan vs. U.S. reports the p-value of
tests that the coefficients in the U.S. regressions in panel A and panei C (both individually and jointly) equal the coefficients in the Japanese regressions in panel
A of T&le 2 for the iikebhood of a new outside appointment. Negative Japan vs. U.S. p-values indicate that the coefficient in Japan is less than the coefficient in
the U.S.
Regressions estimates of the likelihood of appointments of outside directors and directors affiliated with blockholders and performance in the U.S.
Table 3
S.N. Kaplan, B.A. MintonlJournal of Financial Economics 36 (1994) 225-258
-vr&
-
000
c
c‘!\99
o\-vr
-0OrA
.
--c\J
I
.
.
I
I
TX%3
000
ddd
I
I
I
I
241
242
S.N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
changes.] A two-standard-deviation decline in stock returns (5 1%) is associated
with a cumulative 2.6% increase in the percentage of new outside directors
appointed
versus an unconditional likelihood of 8.9%. Negative income is
associated with an increase in the percentage of new outside directors of 3.0%.
Although not directly comparable to the Japanese regression, these results
indicate that the number of new appointments responds modestly to firm
performance in the U.S.
Panel C of Table 3 indicates that blockholder director appointments are
significantly related to stock returns and sales growth, but not to negative
income. In contrast to the results for ou~sidt; director appointments, joint tests
fail to reject the restriction that all coeflicients for the individual performance
variables in the U.S. blockholder equal those in the Japanese outside appointment regressions. In fact, the individual coefficients on two-year lagged stock
returns and sales are more negative in the U.S. than in Japan. Blockholder
appointments in the U.S., therefore, appear to be roughly equally sensitive to
performance as outside appointments in Japan.
It is worth noting, however, that blockholder appointments are appreciably
less frequent, occurring less than 20% as often as outside appointments in
Japan. As a result, the slope estimates in the respective regressions imply
economically different responses to stock performance or negative income in the
two countries. The sensitivities to stock returns in Japan (sum of - 0.195) imply
that a 50% stock decline increases the likelihood of an outside appointment by
10% in Japan, compared to onlv 3% for a blockholder appointment in the U.S.
(sum of - 0.060). Similarly, the iercit*
iD..ivities imply that negative income in Japan
increases the appointment likelihood by 13.2% versus 2.3% in the U.S.
Over+, therefore, appointments of outside directors in U.S. firms are generally less sensitive to stock and earnings performance than are outside appointments in Japanese firms. Mockholder director appointments in U.S. firms are
roughly as sensitive to firm performance as are outside appointments in
Japanese firms, but are appreciably less frequent, occurring in 2.3% of firmyears in the U.S. versus 12.9% of firm-years in Japan.
4. Outside appointments, performance, arndrelationship variables
The results in Section 3 indicate that outside board appointments in Japan are
related to company stock performance and to low earnings. In this section, we
add variables that measure the intensity of the Japanese governance relationships. This analysis can provide evidence as to whether outsiders are appointed
in firms in which banks or other corporations have an ongoing financial interest.
Adding the relationship variables also eliminates any s’purious correlations
between appointments and performance tha,t may be driven by unobserved
correlations between the relationship variables and financial performance. For
S.N. Kaplan, B.A. MintonlJournal of Financiai Economics 36 (1994) 22.5-258
243
example, if firms with high debt tend to appoint bank directors and also tend to
have negative income and poor stock returns, the regressions in Section 3 would
find a spurious correlation between appointments and performance.
To conserve space and focus on the stronger relations, we restrict performance measures to stock returns and negative current income for bank appointments, and to stock returns for corporate appointments.
4.1. Bank appointments
Panel A of Table 4 presents estimates of the determinants of appointments of
bank directors. The likelihood of a bank appointment is significantly related to
firm stock returns m the previous year. Negative current income is also associated with an increased likelihood of a bank appointment of 3.4% in the same
year and 2.0% in the following year, for a total increase of 5.4% (significant at
5%).
Appointments of bank directors are significantly associated with the two
measures of the strength of the main bank relationship. Bank appointments are
most strongly associated (in terms of variation explained) with borrowings to
total assets. In a given year, the likelihood of an a pointment of a bank director
increases by 6.2% (significant at 1%) with a two-standard-deviation
(36%)
increase in borrowings to total assets. Bank appointments also are significantly
related to the fraction of borrowings from the largest lender. A two-standarddeviation (14%) increase is associated with a 3.9% increase in the likelihood of
a bank appointment.
These patterns provide additional support for the view that bank directors are
appointed when there is a bank loan to protect. In contrast, the appointment of
bank directors is not related to the variables measuring shareholdings and
group relationships. Although not reported, we obtain similarly insignificant
results when we measure shareholdings as the equity owned by a firm’s main
bank.
4.2. Corporate appointments
Panel B of Table 4 presents estimates of the determinants of appointments
of corporate directors. Again, stock performance remains significant in the
presence of the relationship variables.
The coefficients for the relationship variables are almost the mirror image of
their values for bank appointments. The two ,main bank variables are not
significantly related to corporate appointments. Instead, corporate appointments are strongly related to share ownership and to the two corporate group
membership variables. The coefficient for the enterprise group variable is particularly noteworthy. The coefficient indicates that the likelihood of a corporate
appointment is 18.4% greater for a member of an enterprise group. This is six
244
S.N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
Table 4
Regressions estimates of the likelihood of appointments of bank and corporate directors versus
performance and relationship measures in Japan
Logit regression estimates of the likelihood that a new director was (A) previously employed by
a bank and (B) previously employed by a different nonfinancial corporation over one-year periods in
Japanese firms as a function of performance and relationship measures for 119 Japanese firms from
1980 to 1988. For bank appointments, performance is measured by stock returns and negative
current income; for corporate appointments, by stock performance only. Relationship measures are
(i) total borrowings to total assets, (ii) the fraction of total borrowings lent by the largest lender, (iii)
the percentage of shares owned by the ten largest shareholders, (iv) a dummy variable equal to one if
Dodwell (1982) indicates the firm is associated with a financial group and equal to zero otherwise,
and (v) a dummy variable equal to one if Dodwell (1982) indicates the firm is associated with an
enterprise group and equal to zero otherwise. All estimations include dummy variables for the time
period. Slope measures the change in the probability of an appointment to a change in the
independent variable implied by the logit coefficients evaluated at sample means. Model p-value
reports the joint significance level of the current and lagged coefficients of the performance variable.
___________~__~
_
_ -.____-
(A) At least one new director
previously employed by
bank
(B) At least one new director
previously employed
by nonfinancial
corporation
Independent variables
Logit
[S.E.]
Logi t
[S.E.]
Stock return
Same period
One lag
Two lags
0.27
- 1.30
0.61
[OS41
0.013
CO.573 - 0.067b
co.541
0.032
- 1.54
- 1.21
0.37
CO.761 - 0.038b
[0.7@] - 0.030’
0.009
co.7 13
Slope
Pre-tax income is negative
Same period
One lag
0.55
0.33
co.401
co.4 13
0.034
0.020
Total borrowings/total assets
3.37
[O.SI]
0.173”
0.80
Fraction of total borrowings
from largest holder
5.50
c2.213
0.282b
Percentage ownership top 10
shareholders
- 0.51
Cl.061
Member financial group
- 0.08
Member enterprise group
0.38
Slope
CO.941
0.019
- 1.35
[2.15]
0.032
- 0.026
3.43
Cl.173
0.082”
CO.301 - 0.004
1.35
co.401
0.030”
co.401
2.74
[0.40]
0.184”
0.022
Model p = 0.01”
Model p = 0.01”
0.075
0.059
Mean dependent variable
N
933
-
“Significantly different from zero at the 1% level.
bSignificantly different from zero at the 5% level.
‘Significantly different from zero at the lO?b level.
93.3
-
-
S.N. Kaplan, B.A. Minton / Journal of Financial Economb 36 (1994) 225- 258
245
times greater than the 3.0% increase implied by the coefficient for financial
group membership.
These patterns provide further support for the view that the two types of
appointments, although related to performance, serve different purposes
and protect different interests. The results suggest that corporate appointments
are meant to protect or support intercorporate shareholdings and relationships.
Such appointments do not appear to be intended to protect the main
bank.
4.3. Performance and relationshipinteractions
The previous analyses do not allow for interactions between the performance
and relationship variables. Previous work by Hoshi et al. (i991) and 1991)finds
evidence of such interactions: Investment is less sensitive to internal cash flow
and to financial distress for firms in financial groups and with strong main bank
relationships. In this section we discuss (but do not report) the results of
regressions that include performance and relationship variable interactions. For
bank appointments, we run separate estimations foi (1) stock returns and (2)
negative current income, and interact those variables with the two measures of
borrowing intensity. For corporate appointments, we run estimations that
interact qtock returns with shareholder concentraticn, financial group membership, and enterprise group membership.
We + not find any significant interactions between the two performance
variab. 5 and the two borrowing variables in the bank appointment estimations.
It is possible that two characteristics of stronger bank relationships - greater
incentives to send an appointment, but better information on the appointing
firm - offset each other. The absence of an interaction is also consistent with
Aoki et al. (1994), who argue that all firms have a main bank whether they have
borrowings or not. For corporate appointments, we find a significant interaction between shareholdings of the top ten shareholders and stock returns in the
same year. The coefficient indicates that corporate appointments are more
sensitive to poor performance in firms with more concentrated shareholdings.
This is consistent with larger ownership positions giving shareholders a
greater incentive and greater power to send outside appointments after poor
performance.
5. The impact of outside appointments on iucumbent managers
The results in the previous sections indicate that outside appointments in
Japanese firms increase significantly with poor firm performtince. Bank,
shareholding, and group relationships a,lso play a role. As noted earlier, there
are two interpretations of those results.
246
S.N. Kaplan, B.A. Mintonl Journal of Financial Economics 36 (1994) 225-258
One interpretation
in that
banks, corporate
shareholders,
and related
corporations play a monitoring and disciplining role in Japanese corporate
governance. One aspect of this role is to send directors to poorly performing
companies to oversee or implement responses to that oar perfori3ance.
Aoki et al. (1994) and Sheard (1994) describe how or t::ain bank’s power
to have one of its employees appointed, often in spite uf opposition from
incumbent management, comes from the bank’s position as lender, shareholder,
and settler of intercorporate payment accounts. Similarly, the power of a corporate shareholder to have a director appointed stems from the shares it owns or
controls. Under this interpretation, the bank and intercorporate relationships
in Japan play a similar role to the external market for corporate control in
the U.S.
Alternatively, the appointment of an outsider in response to poor performance may be required to signal to suppliers, customers, or others that the
bank, the related corporation, or the group is committed to supporting the
appointing firm. According to this view, the main bank more than recoups any
costs of such support by charging above-market fees for services in normal
times. For corporate managers, such a support scheme is attractive because it
provides support for their firm and their jobs when their firms experience
difhculties. [See Coffee (1991) for a detailed discussion of this interpretation.]
This second interpretation suggests that the primary role of an outside appointment is one of insurance, rather than discipline or monitoring. The fact
that most outside appointments are at the level of director - not the more
senior, representative director level - is, on the surface, consistent with this
interpretation.
The monitoring and insurance interpretations have different implications for
incumbent management. If the relationships serve to insure managers, then the
appointment of an outsider should not affect executive turnover. Alternatively, if
the relationships serve to monitor and discipline management, then outside
appointments should be associated with unusually high turnover of incumbent
management. Accordingly, in this section, we test for abnormai top executive
turnover in years of outside appointments.
5.1. Outside appointments and executive turnover
In our tests of incumbent management turnover, we measure turnover in four
ways: (I) turnover of the president, (2) nonstandard turnover of the president, (3)
percentage turnover of representative directors, and (4) percentage turnover of
all directors. We define presidential turnover as nonstandard when a president
steps down and does not become chairman, because a president becomes the
company’s chairman almost 70% of the time he relinquishes the presidency.
Kaplan (1994) finds that nonstandard presidential turnover is more closely
related to poor performance than overall presidential turnover.
S.N. Kaplan, B.A. MintonlJournal of Financial Economics 36 (1994_.l 225-258
247
We regress these four measures of top executive turnover against a dummy
variable that equals one if there is an outside appointment, and zero otherwise.
We present results for one- and two-year periods. Because most firms
appoint directors on two-year cycles, the one-year regressions include a duAmmy
variable that indicates whether a firm is in the year of board appointments or in
an off year. We assume a firm operates on an even-year (odd-year) cycle if the
average number of directorship appointments over the entire sample period is
greater in even (odd) years for that firm. The regressions also include dummy
variables for president age, president tenure, and for the time period. [Kaplan
(1994) finds that the age and tenure variables have significant explanatory power
for top executive turnover in Japan. The time-period variables, as in the
previous regressions, are meant to control for economy- or market-wide
shocks.]
Panel A of Table 5 presents the results for one-year periods. The results
indicate economically and statistically significant increases in all four measures
of execu:;ve turnover. Representative director turnover, for example, increases
by 12.00%, 7.57%, and 10.07%, respectively, in the year a firm appoints a new
bank director, a new corporate director, or either type of outside director. These
increases are large relative to the average turnover of 14.36% per year.
5.2. Outside appointments, executive turnover, and performance
Panel A indicates that outside appointments and abnormally high executive
turnover coincide. The results in this paper and Kaplan (1994) document that
both are associated with poor firm performance. To control for the possibility
that outside appointments have no marginal effect on top executive turnover, we
repeat the tests in panel A, controlling for stock performance and negative
current income. Panel B of Table 5 presents the estimated increase in turnover
controlling for performance. The coefficients decline slightly compared to those
in panel A, but the results are similar. Turnover still increases significantly in the
year of outside appointments. Although not reported, the coefficients on the
performance variables are largely unaffected by the inclusion of the appointment
dummy variables.
It is possible that the types of firms that make outside appointments normally
have high top executive turnover. To control for this, we repeated the analyses in
this section using firm fixed effects (the equivalent of including dummy variables
for each sample firm). This focuses on within-firm variation, eliminating variation across firms. We obtain qualitatively similar results.
Panel C of Table 5 presents the analogous estimates for two-year periods. The
coefficients for a bank appointment or for any outside appointment are similar
to those in panel B. For corporate appointments, the coefficients for president
and director turnover are smaller than over the one-year periods, while the
coefficient for representative director turnover is larger.
_.-_-_.___ ._.__
8 080hb
[4:15]
12.70”
[4.64]
9.76”
C3.27)
New director from (outside) nonfinancial
corporation
New director from bank or (outside)
nonfinancial corpordtion
--
New director from bank
(A) One-year periods, control for directorship
cycle
_ .---_-.
Increase in %
president
turnover
4.15”
co.9 1]
10.07”
Cl.91J
7.17”
[1.91-J
933-944
933-944
2.49’
C1.31)
7.57”
C2.76)
3.04
C2.73)
N
933-944
Increase in %
director
turnover
4 87%”
[1:15]
Increase in %
representative
director
turnover
12.00%”
C2.43J
10.08%”
[2.41-J
Increase in %
nonstandard
president
turnover
Increase in Iikelihood of president turnover, nonstandard president turnover, representative director turnover, and director turnover in periods when new
directors are appointed who have (1) previous experience at banks, (2) previous experience at other nonfinancial companies, and (3) previous experience at
either a bank or nonfinancial corporation. (President turnover is nonstandard when president gives up presidency, but does not become chairman.1
Reported increases in turnover are coefficients on dummy variables for outside appointments in OLS regressions in which management turnover measures
are the dependent variables. Control for directorship cycle controls for whether the firm’s board is appointed on an even- or odd-year cycle. Controls for
performance include stock performance and negative current income variables. The regressions also include dummy variables for president age, president
tenure, and time period. The mean likelihood of president turnover, president turnover not becoming chairman, representative director turnover, and
director turnover are, respectively, 15.1l%, 3.86%, 14.36%, and 12.05% over one year; 30.50%, 7.84%, 28.64%, and 2396% over two years. Standard
errors are in brackets. The number of observations differs because president deaths are considered missing observations.
-- --_--
Top executive turnover in years of outside appointments in Japan
Table 5
periods, control for directorship
from (outside) nonfinancial
L. New director
corporation
Significantly
“Significantly
‘Significantly
- --
drflerent from zero at the 1% level.
different from zero at the 5% level.
different from zero at the 10% level.
-.--
~______
3.74
[4.64-j
3. New director from bank or (outside)
nonfinancial corporation
_ - .- __I___l___________
5.52’
[3.07]
2.19
[4.31-J
6.66
La.231
2. New drrector from (outside) nonfinancial
curporat ion
I. New director
7.70h
[3.86-J
Is, control for performance
5.50”
[I.921
8.49b
[3.34]
2.57%
[S.SS J
per]
2.67
C2.71J
7 64%”
[2:46]
13.04”
[4.68]
5.67%
C4.281
from bank
(C) Two-year
3. New director from bank or (outside)
nonfinancial corporation
from bank
1. New director
cycle and performance
(3) One-year
-------
-- _- - _.-__.
_ __- -_F___I_
__
3.55”
[1.29]
11.71”
[2.88-j
___--_
0.” 3
Cl.751
12.11”
[3.91-J
3.19”
co.90 3
9.36”
Cl.943
5 05%”
Cl:61 J
2.45’
[1.27-j
7.28”
12.761
9 78%”
[3:65]
3 26%”
[1:15-j
11 10%”
[2:48 J
452-466
452-466
452-466
919-933
919-933
919-933
9
*
4
Z?
.3
?
250
S.N. Kaplan, B.A. Minton/ Jb ,dmal of Financial Economics 36 (1994) 225-258
Although mt reported in the table, we also estimated abnormal turnover
in years of appointments of directors with previous government experience.
Government appointments are associated with small declines, not increases,
in standard president, nonstandard president, and representative director
turnover, suggesting that government appointments play a different role than
bank and corporate appointments.
5.3. Compariw
to United Stala
In this section, we estimate the relation between top execlltive turnover and
outside ; ppointments in the U.S. to examine whether , ‘P- *ale of outside
appoir tments in Japan and the U.S. are different. We use two measures of
top executive turnover: CEO and executive director turnover. An executive
director is both a current firm executive and a member of the board of
directors, a definition similar to that of representative directors in Japan.
The U.S. firms have a median of four executive directors. An executive director
turns over when he loses his executive position, his board position, or both.
CEO and executive director turnover average, respectively, 10.4% and 11.7’?/0
per year.
We regress the two measures of top executive turnover against the measures
of outside and blockholder appointments. The regressions include the performance variables associated with outside appointments - stock returns, sales
growth, and negative inc ome - and dummy variables for CEO age, CEO tenure,
and time period.
Table 6 reports the results. They differ from those for outside appointments in
Japan. Top executive turnover does not increase significantly with the appointment of at least one new outside director. For example, the coefficients associate
a new outside appointment with only a 0.35% increase in executive director
turnover. Similarly, the relation of top executive turnover to the percentage of
outside director appointments is insignificant. For example, the coefficients
imply that executive director turnover increases by only I.1 % in a year in which
five new outside directors replace five of ten old outside directors.
We find a somewhat stronger association between turnover and blockholder
director appointments. At a one-year frequency, a blockholder appointment is
associated witn an 8.17% increase in CEO turnover and a 4.64% increase in
executive director turnover. The increases are not statistically significant. At the
same time, however, the increases are not significantly different from the increases in president (8.49?%) and representative director turnover. (9.36%)
associated with an outside appointment in Japan. At a two-year frequency,
a blockholder appointment is associated with an increase of 20.83% in CEO
turnover and 9.27% in executive director turnover (both significant at 10%).
The increase in executive dkector turnover is similar to the 11.71% increase in
representative director turnover associated with an outside appointment in Japan.
Table 6
Top executive turnover in years of outside appointments in the U.S.
The relation of CEO turnover and executive director turnover to (1) the appointment of any new
outside director, (2) the fraction of new outside directors appointed, and (3) the appointment of a new
director affiliated with a blockholder (of at least 5% of the firm’s equity) from 1980 to 1988 for 146
U.S. firms in the 1981 k‘urtrtrreMagazine listing of the 150 U.S. companies with the greatest sales. At
least one new outside director is appointed La 51.5% of one-year periods and 76.4% of two-year
periods; the percentage of new directors appointed is 8.9% and 17.6%, respectiveiy, in one- and
two-year periods; and a blockholder-affiliated director is appointed in, respectively, 2.3% and 3.9%
of one- and two-year periods. Reported increases in turnover are coefficients on variables for outside
and blockholder appointments in OLS regressions in which management turnover measures are the
dependent variables. Controls for performance include stock return, negative current income, and
sales growth variables. The regressions also include dummy variables for CEO age, CEO tenure, and
time period. The mean likelihood of CEO turnover and executive director turnover are, respectively,
10.4% and 11.7% over one year; 20.6% and 23.6% over two years. Standard errors are in brackets.
The number of observations differs because CEO deaths are considered missing observations.
Increase in %
turnover of CEO
increase in % turnover
of executive directors
At least one - -w outside director
1.45%
Cl.831
0.35%
p.131
978-981
New outside directors as % of
initial outside directors
0.065
co.0793
0.022
[0.048]
978-98 1
At least one new director from
blockholder
8.17
C6.083
4.64
[3.72]
978-98 1
0.70%
[2.45]
481-484
0.02 1
CO.0661
481-484
9.27’
[5.58]
_ -.- ______~_
481-484
N
(A) One-year periods, control for
performance
(B) Two-year periods, control for
performance
1. At least one new outside director
3.95%
[3.87]
2. New outside directors as % of
initial outside directors
0.164
[O.1;35]
20.83b
3. At least one new director from
[8.79]
blockholder
_ ____.__
--_- P_______-_P_
bSignifican t1y different from zero at the 5% level.
‘Significantly different from zero at the 10% level.
-- --~ -----
--
Overall, these results provide additional evidence that outside appointments
in the U.S. play a different role from those in Japan. Unlike in Japan, appointments of outside directors are not associated with increased turnover of incumbent top executives. Blockholder appointments are both less strongiy associated
with increased executive turnover and, as noted previously, much less frequent
than outside appointments in Japan.
252
S.N. Kaplan, B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
5.4. Dismssion
Outside appointments in Japan are associated with poor firm performance, and
such appointments coincide with unusually high turnover of incumbent management. Taken together, these results are consistent with an important monitoring
and disciplining role for banks, corporate shareholders, and corporate groups.
It is important to stress that it is not critical for our purposes that the outside
appointments be the actual instruments of discipline or monitoring. Our only
assumption is that outside appointments indicate that the main bank, corporate
shareholder, or corporate group is paying particular attention to the appointing
firm. Nevertheless, anecdotal and case evidence from Aoki et al. (1994), Sheard
(1994), and bankers in private conversations suggest that outside directors
initially perform a monitoring role, providing information to the previous
employers, as well as identifying and firing poorly yerforming managers. That
an outside director in Japan performs these functions and gives his primary
allegiance, at least initially, to his old company rather than to the appointing
company should not be surprising. A main bank, with the ability to withhold
funds, and a corporate shareholder, with the ability to exercise shareholder
votes, can present real and cost ixr
f threats to an outside director and incumbent
managers at a poorly perf:rl ail.;;:; 5,i.
The differences between Jan~n ci;id ?i~ tJ,S. are also consistent with bank and
intercorporate relationships su BS.__;.utiq $12scrn~ extent for an external market
for corporate control. While outsi& q?tMntl;zents tied to a lending or
shareholding relationship were much morz i;ommon in Japan, the external
market for corporate control was much more active in the U.S. during the
sample period. Only 2.5% of the Japanese firms were taken over, compared to
21.9% of the U.S. firms. This understates the differences in external pressure
(versus monitoring from ongoing relationships) because it excludes unfriendly
blockholder share accumulations and unsuccessful takeover attempts, which are
virtually unknown in Japan.
6. Pre- and post-appointment financial performance
If outside appointments in Japan are disciolinary, the appointments ought to
reverse, or at east stop, the deterioration in k3or firm performance. Accordingly, we estimate the abnormal pre- and post-appointment performance of
firms that appoint outside directors. We perform these estimations separately
for bank and corporate appointments because the two types of appointments
raicly coincide, and, therefore may be motivated by different internal problems?
6M~rck and Wakamura (1993) perform a simiiar analysis fcjr financial performance after bank
appointments and find qualitatively similar results.
S.IU. Kaplan, B.A. Minton / Journal of Financial Economics 36
i
1994) 225-258
253
We calculate abnormal performance for each of the seven years from year
- 1 to year +5, where year 0 is the base firm-year. We regress firm perfcrmance: for year t against dummy variables for the calendar year, and for whether
the firm made the relevant outside appointment. Abnormal performance is
estimated as the coefficient on the outside appointment dummy variable. The
abnormal performance estimate for year t, therefore, measures the average
difference in performance between firms that made the relevant outside appointment in year 0 and firms that did not. Because the regressions include calendaryear dummy variables, abnormal performance is relative to the average
performance of all firms in a given calendar year.
Panel A of Table 7 presents the results for bank appointments. Sales growth is
negative from the year before the appointment through two years after; the
decline in year + 1 is significant. Asset growth is negative in all six years from
year - 1 to year + 4, with two of those declines being significant. The declines
finally reverse in year + 5. The ratio of current income to assets follows
a similar patterir. In all seven years presented, current income to assets is
significantly negative (i.e., less than market) for the sample firms. The ratio
improves (i.e., moves closer to zero), although not significantly, from - 1.99%
in year + 1 to - 1.04% in year _p 5. Finally, stock returns are significantly
negative in the year before a bank director is appointed. In the years that follow,
the returns do not differ significantly from zero.
Panel B reports the analogous patterns for firms with corporate appointments. Firms making corporate appointments do not appear to be contracting
or financially distressed. Pre-tax income to assets is not significantly different
from that of the average firm, and is significantly greater than that of
firms with bank appointments. Instead, changes in pre-tax income are negative
in both the year before and the year of the corporate appointments. (The sum of
the changes is significantly negative at the 10% level.) In the same two years,
company stock returns are significantly negative. After year 0, none of the
performance measures differ significantly from zero except for sales and asset
growth in year + 1, which equal 2.39% and 2.51% (significant at 10% )*Those
two growth rates also exceed growth after bank appointments (at the 5%
level).
The results in Table 7 suggest that bank directors are appointed to firms that
are contracting or in financial distress. After the bank directors arrive, these
firms continue to contract, but their performance - as measured by stock returns
and earnings changes - does not deteriorate. Corporate directors, in contrast,
appear to be appointed to firms with other problems that may be partially
earnings related. After the corporate dirF;ictors arrive, the firm sales and asset
growth rebound, and their performance - as measured by stock returns and
earnings - does not deteriorate; if anything, it improves. For these firms, there is
no evidence of the sustained decline or contraction present in firms that appoint
bank directors.
I
j’ear + 5
Year + 4
Year + 3
Year + 2
Year + I
Year 0
\rcar -
I .90
il. 15
-
3.45’
[l.SSJ
2.43
[ I.863
1.73
[ I .66]
r 1.661
-
[ 1.533
[ 1.56)
1.56
- 3.00h
0.32
[ 1.37-J
[ I .24]
[I .29]
-
- 3.94’”
2.32’
-(1.39,
-
-
1.48
[ 1.281
Il.311
- 0.57
1.53
[ 1.35)
-
Asset growth
(in o/o)
[ I .37]
-- 0.X6
Sales growth
(in %)
(A) At least one ncu director appointed from bank
co.413
0.15
0.20
CO.361
10.341
-- 0.11
10.3 I]
0.40
- 0.09
[O.291
10.25)
- 0.13
LO.26J
037
Change pretax
income to assets
(in o/o)
1.77”
l.41b
[O.SS]
LO.531
1.99”
[0.53;]
1.90”
co.553
-
-
1.04”
[O.641
l.22h
[0.60--
-- 1.27h
[0.59 J
-
-
-
-
Pretax income
to assets
(in o/o)
-
-
[4.59]
2.88
E4.001
1.00
[3.71]
3.22
13.38-j
- 0.17
- 0.02
13.141
C3.021
0.00
[ 3.073
- 8.21”
Stock ret urn
(in o/o)
41
458
585
48
53
702
62
819
936
72
935
72
72
934
N = All firm-years
N = Rank appointments
Abnormrrl firm sales growth, asset growth, change in prc-tax income to assets, prc-tax income Icvcls,and stock r&urns before and after appointments of
directors with previous experience at banks or other nonfinancial corporations for 119 Japanese firms from 1980 to 1988. Sales and asset growth are,
rcspectivcly, the annual change in (log) sales and total assets. Change in pre-tax income to assets is the annual change in the ratio of pretax income to total
assets. Abnormal performance is the coefficient [and standard error] from ;L regression of pcerformanccagainst a dummy variable for the relevant atside
appointment. The rcgrcssions include dummy variables for the c&n&r
year, so performance is rclativc to average performance for all firms in a given
year. Year 0 is the year of the appointment.
Abnormal firm pcrformancc around years of outside director appointments in Japan
z
<
2
$
i
.
3
s
*
f/,
:<
S. N. Kaplan, B.A. Min ton/ Journal of Financial Economics 36 ( 1994) 225-258
-
c2
. .
O-
o,Ez
. . &l
. .
OCCI
u
I-
-z
-7
O-
n
r‘.
U
zig
. . s;E
-r-i
O-
0
u
255
256
S.N. Kaplan. B.A. Minton/ Journal of Financial Economics 36 (1994) 225-258
7. Changes in performance-appointment relations over time
Some authors have argued that the deregulation of the corporate bond
market in Japan, which began in the early 1980~~has led to a weakening of the
corporate relationships in Japan, particularly those between firms and their
main banks. For example, Hoshi, Kashyap, and Scharfstein (1993) find that
healthier firms reduced their reliance on bank borrowings in the 1980s. They
conjecture that this may have weakened the ability of banks to monitor or
intervene in firms’ management. Similarly, Kester (1991) argues that deregulation, as well as the operating successes of Japanese companies in the 198Os,
allowed those companies to reduce their bank debt, and thus allowed managers
to distance themselves from monitoring by the main bank and other firms.
If these arguments are correct, appointments of bank and corporate directors
should be less sensitive to performance in the latter part of the 1980s than in the
earlier rPrt. We test for a declining sensitivity by estimating appointment-performance regressions that allow for an interaction between time and
performance. The interaction terms equal the product of the performance
variables and a dummy variable for the period that equals one for firm-years in
the latter half of our sample, from 1985 to 1988. We use both stock returns and
negative current income as performance variables. If the reLtion between
appointments and performance deteriorated over the 198Os, the coefficients on
these interaction terms should be positive.
We find no evidence of a deterioration in appointment-performance
sensitivity. None of the coefficients on the interaction terms in any of our estimations is
significant. At the same time, the coefficients on the noninteracted performance
variables are almost identical to their values in Table 2. While we recognize that
our test using only eight years of data may have limited power to detect a slow
deterioration, it is precisely over those eight years that relationships are alleged
to have weakeired.
8. Summarv. and discussion
This paper has examined the determinants and implications for managers of
appointments of bank and corporate directors in Japanese firms. Appointments
of both types of directors increase significantly with poor stock performance;
those of bank directors increase with negative current income as well. Such
appointments are also associated with variables measuring the intensity of the
relationships governing Japanese firms. We distinguish between monitoring and
insurance interpretations of outside appointments by considering the implications of those appointments for incumbent managers of the sample firms. Top
executive turnover increases substantially in years of outside appointments. We
also compare the post-appointment performance of firms appointing outside
S.N. Kaplan. B.A. MintonlJournal of Financial Economics 36 (1994) 225-258
257
directors with the performance of the other Japanese firms. Performance does
not deteriorate, but improves modestly after outside appointments.
In large U.S. firms, the patterns are different. Appointments of outside
directors in U.S. firms are both less sensitive to performawe and less strongly
associated with top executive turnover than in Japanese firms. While blockholder director appointments in the U.S. are both sensitive to performance and
somewhat related to top executive turnover, such appointments are relatively
infrequent.
These patterns are consistent with an important monitoring and disciplining
role for banks, corporate shareholders, and corporate groups in Japan.
The results are also consistent with the view that the relationship-oriented
system of corporate governance in Japan substitutes for the more marketoriented system in the U.S. Banks, corporate shareholders, and corporate
groups appear to play a role that is similar to that of takeovers and proxy tights
in the U.S. We are unable to say, however, which of the two systems is more
effective.
The results in this paper complement and extend those in Kaplan (1994) and
Merck and Nakamura (1993). Kaplan (1994) documents that top executive
turnover and compensation in Japanese firms are related to firm earnings and
stock performance, particularly to low earnings. Both Kaplan (1994) and Merck
and Nakamura (1993) find that appointments of bank directors increase significantly with poor stock performance and with low earnings. Neither paper,
however, considers the impact of bank or outside appointments on incumbent
managers, and therefore neither distinguishes between the two interpretations of
such appointments. Our results strongly suggest that pressures from banks,
corporate shareholders, and corporate groups play an important Cole in linking
firm performance and managerial rewards.
Finally, our results, like those in Kaplan (1994), dispute one of the supposedly
major advantages of Japanese corporate governance - the ability to ignore
short-term measures of performance. Current earnings and, particularly, current
stock returns are important determinants of outside appointments in Japan. We
favor a simple interpretation to reconcile our results to the widely-held view that
Japanese managers are more long-term-oriented than their U.S. counterparts a company’s current stock price provides a good measure of its current and
future prospects.
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