Japan's Board Effectiveness Challenge: Why Do Some Listed Companies Struggle with "Dysfunctional Boards" and What Are the Solutions?

Effective corporate boards are the linchpin of robust corporate governance globally, tasked with strategic oversight, executive accountability, and safeguarding shareholder interests. In Japan, while many listed companies operate with effective boards, there has been a recognized and periodically highlighted challenge concerning what is sometimes termed "dysfunctional boards" (取締役会の無機能化 - torishimariyaku-kai no mukinōka). This issue refers to situations where the board of directors may not fully exercise its critical functions of substantive deliberation and robust oversight of management. This article delves into the traditional structures and practices within some Japanese listed companies that have contributed to this phenomenon, and explores the legislative solutions, primarily within the Companies Act (会社法 - Kaisha-hō), designed to bolster board effectiveness.

The Traditional Japanese Board: Legal Equality vs. De Facto Hierarchy

Under the Japanese Companies Act, the board of directors (取締役会 - torishimariyaku-kai) holds a central position in corporate governance. Its legally mandated functions typically include making important business decisions and supervising the execution of duties by directors and executive officers. The Companies Act provides for different categories of directors, such as representative directors (代表取締役 - daihyō torishimariyaku), who have the authority to represent the company and execute its business, other directors who may be specifically designated to execute business (業務執行取締役 - gyōmu shikkō torishimariyaku), and "plain" directors (平取締役 - hira-torishimariyaku) who primarily participate in board deliberations and oversight.

Legally, all directors are considered to be of equal standing in their capacity as board members, a principle intended to foster open discussion and mutual supervision. However, in practice, a de facto internal hierarchy often emerges within many Japanese companies, which can subtly undermine this legal equality and, consequently, the board's overall effectiveness. Several traditional factors contribute to this:

1. Internal Corporate Ranks (内部職階制 - naibu shokkai-sei): Many Japanese companies maintain a detailed internal hierarchy with titles such as President (Shachō), Vice-President (Fuku-shachō), Senior Managing Director (Senmu), and Managing Director (Jōmu). While these titles often correspond with directorships, they also create an operational chain of command and status distinctions that can carry over into the boardroom. Directors who also hold senior executive titles may wield significantly more influence than those with less senior titles or plain directorships, potentially stifling candid debate or dissent from those lower in the pecking order. This system, while arguably efficient for day-to-day business execution, can conflict with the board's role as a body of equals engaged in oversight.
2. Promotion of Directors from Within (従業員出身の取締役 - jūgyōin shusshin no torishimariyaku): A common career path for directors in many Japanese companies involves long-term employment and gradual promotion through the ranks. While this ensures directors have deep company-specific knowledge, newly appointed directors promoted from managerial positions may find it challenging to independently question or supervise senior directors who were once their superiors. This ingrained deference can perpetuate a hierarchical, rather than collegial, boardroom dynamic.
3. Directors Concurrently Serving as Employees (使用人兼務取締役 - shiyōnin kenmu torishimariyaku): It has been a widespread practice for directors, particularly those who are not top executives like the President, to concurrently hold operational employee positions, such as a General Manager of a department (e.g., "Director and General Manager of General Affairs"). This dual role can further blur the lines between management and oversight. A director who is also an employee reporting to a more senior executive (who might also be a director) may prioritize their employee responsibilities or feel constrained in their oversight capacity. Historically, this practice was also influenced by tax regulations, where bonuses paid to employees (even if they were also directors) were more favorably treated than bonuses paid purely to directors. While tax laws have evolved, the practice, driven also by a desire to effectively utilize experienced personnel, has contributed to the complex hierarchies within and around the board.

The cumulative effect of these factors can be a board environment where critical discussion is limited, and the oversight function is weakened, leading to a board that may, in some instances, resemble a "rubber-stamping" body for decisions already made by top management rather than a forum for robust strategic debate and independent supervision.

The "Dysfunctional Board": A Latent Concern

The issue of "dysfunctional boards" does not imply that a majority of Japanese boards are ineffective all the time. Rather, it points to a latent vulnerability within the traditional system where, under certain conditions, board functionality can be compromised. Such dysfunctions often come to public attention during corporate scandals, revealing instances where critical checks and balances may have failed. The concern is that a board dominated by internal hierarchies and lacking sufficient independent voices might not adequately challenge management, approve strategic decisions without thorough scrutiny, or effectively oversee risk management and compliance, potentially harming shareholder value and the company's long-term integrity.

Early Legislative Responses: An Auditor-Centric Approach

For many years, legislative responses to corporate governance challenges in Japan, particularly those highlighted before the significant reforms of the early 2000s, tended to focus on strengthening the role and powers of statutory auditors (監査役 - kansayaku) and the audit & supervisory board (監査役会 - kansayaku-kai) rather than directly overhauling the structure and composition of the board of directors itself. This indirect approach was partly due to resistance from segments of the business community, which were cautious about reforms that might impede established (and often effective for business execution) management practices.

This auditor-centric model, however, had limitations, especially when compared to evolving international corporate governance norms, particularly those in the United States. Western models increasingly emphasized the board of directors as the primary organ for management oversight, with a strong focus on the role of independent (outside) directors. Key tenets of this approach included the idea that effective supervision often requires perspectives independent from internal management and that the supervising body should ideally have the power to appoint and dismiss senior executives. While Japan did introduce the concept of outside statutory auditors (社外監査役 - shagai kansayaku) to enhance auditor independence, statutory auditors in the traditional Japanese system do not have the direct power to appoint or remove directors or executives; that power resides with the shareholders' meeting and, for representative directors, often effectively with the board.

Modern Solutions: Restructuring the Board for Enhanced Oversight

Driven by increasing globalization, the expectations of international investors, and a domestic impetus for stronger governance, Japanese corporate law has seen significant reforms aimed directly at the board of directors. These reforms have introduced alternative governance structures that companies can adopt, designed to foster more effective oversight and align more closely with global "monitoring board" models.

1. The "Company with Nominating Committee, etc." (指名委員会等設置会社 - shimei iinkai tō setchi kaisha)

Introduced by amendments to the Commercial Code in 2002 and carried into the Companies Act, this model represents a significant departure from the traditional Japanese board structure. Its key features are:

• Three Mandatory Committees: Such companies must establish a Nominating Committee, an Audit Committee, and a Remuneration (Compensation) Committee.
• Outside Director Majority: Crucially, each of these three committees must have a majority of its members being outside directors (社外取締役 - shagai torishimariyaku). This is intended to ensure independence in key areas of director nominations, audit oversight, and executive compensation.
• Separation of Oversight and Execution: In this model, the board of directors focuses on oversight and strategic decision-making. The actual day-to-day execution of business is delegated to "Executive Officers" (執行役 - shikkō-yaku) appointed by the board. Directors themselves (with limited exceptions for also being executive officers if a majority of the board approves, though this is rare in practice for maintaining role clarity) are generally prohibited from directly engaging in business execution in their capacity as directors.
• No Concurrent Employee Status for Directors: Directors in these companies are prohibited from concurrently serving as employees of the company or its subsidiaries. This further reinforces their independent oversight role.

This structure aims to create a "monitoring board," where a board largely composed of or heavily influenced by independent outsiders supervises a separate executive team. The board's core functions include appointing and dismissing executive officers and representative executive officers, and determining fundamental corporate strategy.

2. The "Company with an Audit and Supervisory Committee" (監査等委員会設置会社 - kansa tō iinkai setchi kaisha)

Introduced by the 2014 amendments to the Companies Act, this model offers another path to strengthened board oversight, generally considered less disruptive to implement than the Nominating Committee model for many traditional Japanese companies. Its main characteristics include:

• Mandatory Audit and Supervisory Committee: The defining feature is an Audit and Supervisory Committee, which is a committee of the board itself. This committee must consist of three or more directors, the majority of whom must be outside directors.
• Audit Functions: The Audit and Supervisory Committee is responsible for auditing the execution of duties by directors and executive officers, preparing audit reports, and holding certain powers regarding the appointment and remuneration of the company's external accounting auditor.
• Directors Can Execute Business: Unlike the Nominating Committee model, directors in this structure (including representative directors and other executive directors) are still primarily responsible for business execution.

This model is often seen as an evolution of the traditional statutory auditor system, but with the audit function brought directly within the board and empowered by a majority of outside directors on the committee. It provides a way for companies to enhance independent oversight without fully separating the roles of directors and executives as starkly as in the Nominating Committee model. For companies that have well-qualified outside statutory auditors, transitioning them to become outside directors on an Audit and Supervisory Committee can be a relatively smoother path to reform. Furthermore, if a Company with an Audit and Supervisory Committee has a majority of its full board composed of outside directors, the Companies Act allows for a significant delegation of business execution decisions from the board to individual directors (typically representative or executive directors), enabling the board to function more like a monitoring body.

The Central Role and Rise of Outside Directors

Both of these modern governance structures underscore the increasing importance and expected role of outside directors in Japanese corporate governance. The premise is that outside directors, being independent of internal management and less likely to be embedded in the traditional corporate hierarchies, can bring objectivity, diverse perspectives, and a more critical stance to board deliberations and oversight functions.

Japan's Corporate Governance Code, first implemented in 2015 and subsequently revised, has further accelerated this trend by calling for listed companies to appoint a certain number of independent outside directors. While the definition of "independence" and the actual impact of outside directors continue to be subjects of discussion and refinement, their presence is increasingly seen as indispensable for effective board functionality and for aligning Japanese governance practices with global standards. The Code encourages boards where outside directors play a principal role in supervising management and key governance areas.

Challenges and the Path Forward

The introduction of these alternative governance structures and the push for more outside directors represent significant steps in addressing the "dysfunctional board" challenge. However, the journey is ongoing. Adoption rates of the Nominating Committee model, for instance, have been modest, though the Audit and Supervisory Committee model has seen wider acceptance since its introduction.

Challenges remain, including ensuring the "true" independence and effectiveness of outside directors, fostering a boardroom culture that genuinely embraces diverse opinions and robust debate, and navigating the transition from deeply entrenched traditional management practices. The definition of director independence, the process for selecting outside directors, and the information and support they receive are all critical factors that influence their ability to contribute meaningfully.

As noted in legal scholarship, the reforms to the Japanese board system are part of an ongoing process of re-evaluation and adaptation, reflecting a continuous search for the optimal balance between managerial efficiency and effective oversight in the specific context of Japanese corporate culture and economic environment.

Conclusion

The challenge of ensuring board effectiveness in some Japanese listed companies has stemmed from a complex interplay of traditional corporate structures, internal hierarchies, and promotion practices that could, at times, dilute the board's crucial oversight role. In response, Japanese corporate law has evolved significantly, offering new governance models—the Company with Nominating Committee, etc., and the Company with an Audit and Supervisory Committee—that place a strong emphasis on independent oversight, primarily through the enhanced role of outside directors.

While these legislative solutions provide robust frameworks for improved governance, their ultimate success hinges on their effective implementation by individual companies and the cultivation of a corporate culture that genuinely values independent scrutiny and strategic guidance from the board. The path of board reform in Japan is one of continuous improvement, reflecting a commitment to strengthening corporate value and stakeholder trust in an increasingly globalized and demanding economic landscape.