Unnatural Selection of Outside Directors: Consequences of Japanese Corporate Governance Reforms

We examine whether firm compliance with the corporate governance reforms is associated with enhanced effectiveness of corporate governance in practice. Past literature has cast doubts on the efficacy of the “one-size-fits-all” approach and pointed out the possibility of in-form compliance, decoupling substance from appearance. Regarding this issue, we focus on the rapid increase in the number of outside directors in Japanese markets driven by the new corporate governance code and amended Companies Act. We find that, after implementation of the governance reforms, there is an increase in cases in which a company’s former auditors become new outside directors for the same company. We also report that firms that had no outside directors prior to the reforms are more likely to engage in decoupling owing to their innate unwillingness to change and redeploy former company auditors as new outside directors. Moreover, we find no evidence that increases in the number of outside directors are related to a firm’s future performance. We provide consistent but new evidence on the prediction of institutional theory and it suggests that firms tend to decouple their appearance of compliance from their practices when they have lower incentives to change.