The Effects of Ownership and Capital Structure on Board Composition and Strategic Diversification in...

THE EFFECTS OF OWNERSHIP AND CAPITAL STRUCTURE

303

© Blackwell Publishing Ltd 2005. 9600 Garsington Road, Oxford,OX4 2DQ, UK and 350 Main Street, Malden, MA 02148, USA.

Volume 13 Number 2 March 2005

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CORGCorporate Governance: An International Review0964-8410Blackwell Publishing Ltd. 2005March 2005132

THE EFFECTS OF OWNERSHIP AND CAPITAL STRUCTURECORPORATE COVERNANCE

*Address for correspondence:School of Business, SingaporeManagement University, 469Bukit Timah Road, Singapore259756. Tel:

+

65-6822-0731;Fax:

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65-6822-0777; E-mail:[email protected]

The Effects of Ownership and Capital Structure on Board Composition and Strategic Diversification in Japanese Corporations

Toru Yoshikawa* and Phillip H. Phan

The board of directors plays an important role in solving the agency problem betweenshareholders and management. This paper investigates the relationships between ownershipand board structure with the diversification strategy of large Japanese firms. The results showthat corporate nominee directors are associated with lower levels of product diversification oftheir investee firms. This suggests that nominee directors in large Japanese corporations seethemselves representing specific interests and therefore investors should pay attention toboard composition in order to assess the level of protection they can expect to receive. Evenwithout any apparent agency problem with management, there remains a potential “principal-principal” problem.

Keywords: Corporate governance, ownership structure, board of directors, diversification,Japanese firm

Introduction

he board of directors plays an importantrole in solving the agency problem

between shareholders and management. Priorstudies have examined board characteristicsthat uphold the interests of shareholders bypromoting corporate strategies that maximiseshareholder value (Dalton

et al.

, 1998). Thesestudies have been largely based on the Anglo-American model of corporate governance.Within the Japanese context the role of theboard in influencing corporate strategy andperformance has been less studied.

1

Partly, thisis because Japanese corporate boards, whichcomprise mostly executives and formeremployees, do not traditionally see them-selves as active monitors of top management.Hence, the Japanese board has not been asactive as its American or UK counterparts.

T

However, this situation may be changing withthe globalisation of corporate governancestandards.

In this study, we focus on a feature of theJapanese corporate boardroom that deservesattention because of its implications for boththeory and practice. Specifically, we examinethe role of the outside directors. There are asmall number of outsider directors on manyJapanese boards who act as representatives ofcorporate and banking institutional investors.Because these institutional shareholders com-monly have commercial relationships with thefirms to which they appoint nominee direc-tors, it is likely that such directors representthe interests of those shareholders.

2

In short,such nominee directors serve to narrow theconflict of interests between management andcertain classes of shareholders. Here we exam-ine how Japanese domestic institutional inves-

304

CORPORATE GOVERNANCE

© Blackwell Publishing Ltd 2005


tors, who are often business partners oraffiliated firms, influence the corporate strat-egy of investee firms through the directorsthey appoint into the boardroom. Japan pro-vides an ideal context to study the relation-ships between ownership structure, nomineedirectors and corporate strategy because of theprevalence of formal and strong inter-firm ties.

Literature review

Agency theory attempts to address the prob-lems that arise from the conflict of interestsbetween parties to a contract in which theagent has control over the transaction-specificassets of the principal (Fama, 1980; Jensen andMeckling, 1976). As residual risk bearers,shareholders have a right to claim the residualvalue

3

generated from the firm’s productiveactivities. However, management decides howthis residual is disbursed and, because it doesnot always own a significant amount of shares,has little incentive to disburse all back to thestockholders. To address this

agency problem

the corporate governance system incorporatesa variety of monitoring mechanisms, such asthe board of directors and direct action bylarge shareholders such as institutions andwealthy individuals (Fama, 1980; Fama andJensen, 1983).

Institutionally, boards of directors owe afiduciary duty to the shareholders of the firm(Monks and Minow, 1995). Thus, it becomes amatter of theoretical and practical interest toexamine how effective and in what waysboards have been able to fulfil these duties.Consequently, a number of studies have inves-tigated the impact of such factors as board size(Pfeffer, 1972; Pfeffer and Salancik, 1978; Singhand Harianto, 1989; Zahra and Pearce, 1989;Goodstein

et al.

, 1994; Dalton

et al.

, 1999) andcomposition (Chaganti

et al.

, 1985; Kosnik,1987; Schellenger

et al.

, 1989; Baysinger

et al.

,1991) on corporate strategy and firm perfor-mance. A number of literature reviews, con-cluding that evidence on what drives boardeffectiveness is mixed (cf. Dalton

et al.

, 1998),recommend that future studies adopt a morecontextually sensitive approach because, forexample, a difference in national context canlimit the applicability of standard agencytheory assumptions of investor risk prefer-ences, managerial behaviours and boardstructures.

In Japan, as in most countries, the board ofdirectors is legally responsible for the monitor-ing of the management. However, unlike theirUS counterparts, Japanese directors do notdelegate their managerial duties to executiveofficers (Heftel, 1983). In part, this is because

board positions are usually conferred to afirm’s loyal current and former employees andare thus seen as part of the managerial hier-archy (Abegglen and Stalk, 1985; Charkham,1994). Japanese board culture often viewsboard members as

de facto

managers and thussubordinate to the CEO. In short, directors arenot expected to question executive manage-ment in the boardroom.

The few outside directors that serve in theJapanese corporate governance system areusually nominees of the banks and corpora-tions that invest in the firm (Kishida, 1996).According to the extant literature, such nomi-nee directors often act as stewards of the com-mercial, rather than investment, interests oftheir institutional investors (Gerlach, 1992).These “stable” investors are not as driven tomaximise returns on investments as the“market” investors. This is because the objec-tives of a commercial relationship and that ofan investment relationship can sometimesconflict with the costs of protecting the com-mercial relationship ultimately borne by theinvestors. For example, a bank is usually con-cerned with protecting the quality of its loans,which translates to higher cash reserverequirements on the client’s balance sheet. Onthe other hand, equity investors want theexcess cash to be returned so they can be rein-vested more productively (Jensen, 1986).

In short, every strategic objective has a cor-responding claim on cash flows and the result-ing conflict between the various interests andstrategic objectives represented by nomineedirectors can be incompatible. The strategicobjective that is eventually pursued willdepend on the relative power of these groupsof nominee directors to influence topmanagement.

For example, bank and corporate share-holders may not have the same investmentobjectives because they have different strate-gic goals. Bank shareholders are interested inprotecting their loan portfolios while corpo-rate shareholders want to stabilise supplier–customer commitments or the strategiccomplementarity of their affiliated firms. Theupshot is that different shareholders with dif-ferent strategic objectives would attempt toinfluence where and when managers investthe firm’s resources. This theoretical frame-work forms the basis for our research model.

Hypotheses

Figure 1 illustrates our research model. This isa two stage temporal model in which we firsthypothesise the effects of ownership and capi-tal structure on board composition, followed


305



by the effects of board composition on diver-sification strategy. This approach isolates theeffects of ownership and control and boardcomposition on strategy, which allows us toexamine the relative impact of each variableand to make conclusions about causality.

Effects of ownership and capital structure on board composition

Japanese shareholders can be broadly classi-fied into two categories known as “stableinvestors”, who are mostly domestic institu-tions, and “market investors”, who are mostlyforeign institutions (Gerlach, 1992). In 1999,stable investors such as

keiretsu

firms, mainbanks and insurance companies controlledapproximately 38 per cent of the equity inJapanese firms (NLI Research Institute, 2002).Conventional thinking suggests that stableinvestors own shares as a means to

stabilise

commercial relationships rather than to earnreturns on investments (Clark, 1979; Gerlach,1992). Therefore, when stable investorsappoint outside directors, known as nomineedirectors, it is with the objective of protectingtheir commercial relationships. Because afirm’s or a bank’s commercial relationship isimpacted by its cash flows, which are theresult of its business strategies, nomineedirectors can stabilise a firm’s relationshipsby influencing its strategies (Prowse, 1990;Gerlach, 1992; Kaplan and Minton, 1994). Forexample, a number of publicly listed Japanesefirms such as Aiwa and JVC are affiliated withSony and Matsushita, respectively. Thus, bynominating directors to these firms, Sony andMatsushita can more easily influence the strat-egies of their affiliated firms. In sum, weexpect to see a relationship between a firm’sownership patterns and the structure of theboard, such that:

Hypothesis 1a: Corporate ownership is posi-tively associated with the number ofcorporation-nominated directors.

Hypothesis 1b: Bank ownership is positivelyassociated with the number of bank-nominateddirectors.

In addition to equity holdings in their cor-porate partners and clients, banks are alsofinancially exposed to their clients’ strategicdecisions through the loans they carry. Thus,the higher the exposure, the greater the incen-tive for the bank to exert direct influence overthe firms’ strategic objectives, which they canattempt to do through nominee directors.Moreover, because a bank’s loan exposure istypically larger than its equity holdings andbecause these loans represent “leveraged” lia-bilities with corresponding obligations todepositors, the incentive to protect the down-side risk is higher than the incentive to maxi-mise its upside gains from their shareholdings.Therefore, we would expect a relationshipbetween a firm’s financial structure and itsboard structure such that:

Hypothesis 1c: A higher proportion of bankloans in the firm’s capital structure is positivelyassociated with the number of bank-nominateddirectors.

The effects of nominee directors on diversification

Corporate and bank nominee directors exertinfluence on the direction of an investee firm’sgrowth strategies according to the interests oftheir parent companies and banks, and in pro-portion to the degree of control they exercisein the boardroom. Within the portfolio ofavailable strategies for growth, firms canchoose diversification.

Diversification, or the entry of the firm intonew businesses or product lines not directlyconnected to its primary business, is a way toincrease the scope and size of the firm whileat the same time reduce its dependence on thecore business. Diversification can help the firmlower overall operating risks by creating aportfolio of businesses with uncorrelated cash

Figure 1: The impact of ownership and capital structure on board structure and strategic diversificationin Japanese corporations

Corporate ownership

Bank ownership

Bank loan/Liabilities

Corporate directors

Bank directors Diversification

+

+

+

–

306




flows, i.e. smooth out earnings fluctuations.However,

ceteris paribus

, diversificationrequires a firm to reduce the intensity of itsinvestments in a single business and thereforemay compromise the building of a sustainablecompetitive advantage in that business(Wernerfelt, 1984; Porter, 1985).

Since corporate shareholders have lessdirect

financial

exposure to their partner firms,we expect that they will be more willing toaccept higher operating risks (i.e. instabilityin cash flows) than bank shareholders, inexchange for a focused business strategy thatincreases the potential for competitive advan-tage. Therefore, we posit that the pressure forstrategic diversification is lower for corporateshareholders than it is for bank shareholders.Further, strategic complementarity, defined asthe coherence of an investee firm’s strategywith that of the parent’s overall corporatestrategy, is an important consideration for cor-porate nominee directors. For example, aparent corporation might find a diversifiedaffiliate more complicated and costly to man-age than one that is less diversified. The cor-poration may also run the risk of a diversifiedaffiliate cannibalising its product markets ifthere are similarities in technology or geo-graphic scope between the two organisations.From a strategic perspective, therefore, a cor-poration would prefer its affiliate to focus ona defined set of businesses that can add valueto its overall strategic portfolio. In sum, weexpect to find a relationship between boardstructure and corporate strategy such that:

Hypothesis 2a: The number of corporation-nominated directors on the board is negativelyassociated with diversification.

The theory of incomplete contracts holdsthat a firm requires predictable cash flows todischarge its implied and explicit obligationsto lenders, employees, suppliers and custom-ers in exchange for their willingness to commitlong-term, transaction-specific resources to thefirm. For example, stable employment isnecessary if the firm expects employees toreduce their investments in general humancapital in favour of firm-specific human capi-tal. Therefore, from the perspective of the banknominee director, stable cash flows are a nec-essary condition for a bank’s objective ofreducing the default risk of its loan portfolio.Cash flow stabilisation at the corporate levelcan be achieved through strategic diversifica-tion into other businesses. Thus, we expect tosee a relationship between board structure andcorporate strategy such that:

Hypothesis 2b: The number of bank-nominateddirectors on the board is positively associatedwith diversification.

Data and methods

Sample and data

The sample for this study consists of 228 pub-licly traded Japanese firms taken from thepopulation of the 300 largest manufacturingfirms listed on the Tokyo Stock Exchange forthe period between 1996 and 1998. Thus, wehave 684 observations for the panel analysis.We focused on manufacturing sectors to limitindustry level effects and exclude those firmsfor which we could not collect complete databetween 1996 and 1998. The Internet boomand subsequent crash between 1999 and2001 would have substantively influenced theinvestment decisions of Japanese corpora-tions, which is why we limited our observa-tions through to 1998. Sample firms arecategorised into one of the following eightindustries; textiles, chemicals, pharmaceutical,ceramics, steel and metals, machinery, elec-tronics and automotive. Data for this studywere collected from the following sources:

Kaisha Shikiho

(Japan Company Handbook),

Yakuin Shikiho

(Board of Director Handbook)and

Kigyo Keiretsu Soran

(List of CorporateKeiretsu). These sources are the same onesused by other researchers and industry ana-lysts have culled information and they con-tained the latest financial and organisationaldata for the sample firms.

Measurement

(a) Dependent variables

We used two dependent variables in the firststage of the model: the number of outsidedirectors nominated by corporations (

corporatedirectors

) and the number of outside directorsnominated by banks (

bank directors

). Manystudies in corporate governance commonlyuse ratios of outside to inside directors,although there is little consistency on howthese measures are computed (Johnson

et al.

,1996). Since we are trying to measure thepower of

shareholders

over their investee firms,we chose to use the number of directors as thisreflects the ability of shareholders to get theirnominees appointment to the board. Further-more, coalition theory suggests that regardlessof total board size, a few individuals with acommon goal can build a coalition that canexert influence disproportional to their rela-tive size. Finally, when directors have thebacking of major shareholders such as the cor-porate parent or main bank, their influence asa coalition is even greater. The data source forthese variables is

Yakuin Shikiho

(Board ofDirector Handbook).


307



Diversification

is the dependent variable forstage two of the model. Following previousstudies on diversification strategy in Japanesefirms (Geringer

et al.

, 2000; Lu and Beamish,2004), we measured diversification with aHerfindahl index, which is the sums ofsquares of sales contribution to total sales bythe individual product groups as classified bythe

Kaisha Shikiho

(Japan Company Hand-book). Geringer

et al.

(2000) calculated a simi-lar diversification measure from the

KaishaShikiho

data. This measure of diversificationdiffers from those using Standard IndustrialClassification (SIC) codes in the US because itmeasures diversity at the product rather thanbusiness level. Our measure is finer grainedbecause it differentiates between differentproduct lines in a single business that an SICbased measure would not ordinarily detectbecause many businesses have multiple prod-ucts within an industrial class. Therefore, weexpect more variance in our measure relativeto other measures using standard SIC codes.

(b) Independent variables

There are three independent variables in thefirst stage of the model: corporate ownership,bank ownership and bank debt.

Corporateownership

is measured as the ratio of the totalnumber of shares held by non-financialcorporations to total outstanding commonshares. Similarly,

bank ownership

is measuredas the ratio of number of shares owned bybanks to total outstanding common shares.

Bank debt

is the proportion of bank loans tototal liabilities. A higher ratio indicates aheavier reliance on bank loans for debt finan-cing, and thus more exposure to the influenceof bank nominated directors.

At the second stage of the model, weincluded

board composition

as the numbers ofnominee corporate directors and nomineebank directors. This is the same measure weused for the dependent variables in the firststage of the model.

(c) Control variables

In this study, we used four control variables.

Foreign ownership

is the ratio of shares ownedby foreign investors to total outstandingshares. This variable indicates the degree towhich a firm is exposed to pressures frommarket-oriented investors and is therefore lessfree to respond to the strategic interests ofdomestic stable investors. Since most foreignshareholders are arm’s-length investorswith no on-going business ties, we expectthat their greater holdings will lead the firm

and its directors to respond with efficiency-maximising resource allocation policies.

The log of

sales

controlled for the effects ofeconomies of scale and scope.

Debt ratio

wasincluded to control for the effects of debtfinancing. In a fixed effects model, one doesnot include variables such as “industry” thatare independent of time. In an approach sug-gested by Dess

et al.

(1990), we accounted forthe systematic impact of industry effects byusing an industry mean value of Tobin’s Q(Industry Q) based on the categorisation pro-vided by the

Kaisha Shikiho

.

Data analysis

To test our hypotheses, we report the resultsof the panel analysis using fixed effectsGeneral Least Squares (GLS) regression for the1996–1998 dataset. A Hausman Test suggeststhat a fixed-effects model is preferred overa random-effects model because the nullhypotheses for both models were rejected, i.e.the random effects estimator is biased(Kennedy, 1998, pp. 305–307). Hence, we usedthe fixed-effects model.

Table 1 reports the Pearson correlations ofthe variables. It shows that the number ofnominee corporate directors is positively cor-related with corporate ownership and nega-tively correlated with bank ownership. Thenumber of nominee bank directors was nega-tively correlated with corporate ownershipbut positively corrected with bank loans.There was no relationship between bank own-ership and the number of bank nominee direc-tors, which seems to suggest that banks withgreater loan exposure are more likely to seekthe appointment of directors. Finally, we notethat the number of corporate nominees isnegatively correlated to the number of banknominee directors, suggesting a limit to thesize of the board. Overall, the picture suggeststhat bank and corporate nominee directorsplay different roles in the boardroom.

Results

Table 2 reports on part one of the panel dataanalysis. As seen from this table, corporateownership is strongly and positively associ-ated with the number of nominee corporatedirectors, supporting Hypothesis 1a. Corpo-rate ownership is negatively related to thenumber of bank nominee directors, suggestingthat corporate owners are able to exert theirclaims to the exclusion of the bankers if theirownership stakes are high. The result alsohints at the possibility that bank and corporatenominees have opposing interests.

308




Bank ownership is not related to the numberof nominee bank directors, rejecting Hypoth-esis 1b. We also do not find a statistically signi-ficant positive association between the bankloan ratio and the number of nominee bankdirectors, thus there is no support for Hypoth-esis 1c. Overall, we find that the part of themodel related to bank directors is not sup-ported by the data. The variance explained issmall and more importantly, the regressionmodel is not statistically significant.

We find an unexpected positive relationshipbetween bank ownership and corporatedirector and a negative relationship betweencorporate ownership and bank director. Thisfinding will be explored in greater depth in thediscussion.

Table 3 reports the second part of the paneldata analysis. It shows that the number of cor-porate directors and diversification strategyare negatively associated, which provides sup-port for hypothesis 2a. However, we do notfind any relationship between the number ofbank directors and diversification strategy,rejecting Hypothesis 2b. The results alsoreport that corporate director accounted for anadditional 2 per cent of variance explained,which is significant, given that the model isconstrained with only 3 per cent of varianceexplained by the control variables. In terms ofthe control variables, Industry Q is negativelyassociated with diversification implying thatindustries populated by more diversifiedfirms are less profitable.

Discussion and conclusions

Overall, we found that the data provided sup-port for about half the research model. Weargued that Japanese institutional investorsare able to exert their strategic preferences inthe boardroom through nominee directorappointments. In some ways, our approach isclassic agency theory because it assumes thatdirectors act to represent the interests of thoseinvestors who appoint them. However, aspart of a growing stream of research (e.g.Gedajlovic

et al.

, 2005; Thomsen and Pedersen,2000), our approach moves us away from thestandard agency theory treatment of share-holders as either atomistic investors with noinfluence over management or concentratedinvestors who coordinate their actions to max-imise shareholder value. We attempted toshow that Japanese outside directors servetheir parent or affiliated institutional share-holders whose interests are not always tomaximise their equity investment returns. Inthis study, we recognise that directors, whenconfronted with an identifiable shareholder

Tabl

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309



constituency, will likely act to advance thatgroup’s narrow interests.

We found that Japanese corporate owner-ship is positively related to the number ofnominee corporate directors and, not unex-pectedly, negatively associated with the num-ber of nominee bank directors. This resultseems to strengthen the argument that share-holders attempt to exert influence in theboardroom through the nomination of direc-tors who can represent their interests. Thisconclusion is further strengthened by the find-ing that corporate directors preferred lessstrategic diversification, and instead focusedthe firm’s resources toward core businessactivities.

We found a puzzling positive correlationbetween Japanese bank ownership and thenumber of corporate directors. However, theeffect size is only about 20 per cent of the re-

lationship between bank ownership and cor-porate directors. We note that the correlationtable (Table 1) reports a positive correlationbetween debt and bank directors, which is inline with our research model. It turns out thatthose firms with corporate nominees are usu-ally affiliated with corporate groups or aresubsidiaries of larger parents. This findingdeserves further research, but we can specu-late that banks may be viewing these affilia-tions as implicit hedges against loan risks,since the hub firms of Japanese businessgroups or

keiretsu

have traditionally bailed outaffiliates that run into financial difficulties(Sheard, 1994).

We did not find any relationship betweenthe number of bank nominee directors anddiversification. A possible reason is that Japa-nese firms performed poorly in the late 1990sbecause of a prolonged domestic recession

Table 2: Results of fixed effects panel analysis of ownership structure on nominee directors

Corporate director Bank director

Beta T-value Beta T-value

Debt ratio

-

0.008

-

1.16

-

0.010

-

1.43Foreign ownership 0.007 0.94

-

0.017

-

2.30*Log sales (size) 1.334 4.04‡ 0.050 0.16Industry Q

-

0.032

-

0.21 0.054 0.38Corporate ownership 0.105 9.88‡

-

0.021

-

2.04*Bank ownership 0.021 3.21†

-0.003 -0.46Bank loan 0.001 0.33 0.004 1.55

R2 = 0.23; F = 18.97‡; Obs = 684

R2 = 0.02; F = 1.62; Obs = 684

‡p < 0.001, †p < 0.010, *p < 0.050.

Table 3: Results of fixed effects panel analysis of nominee directors on diversification

Diversification

Beta T-value Beta T-value

Debt ratio -0.022 -0.36 -0.035 -0.58Log sales (size) -7.511 -2.63† -5.291 -1.82Foreign ownership -0.068 -1.01 -0.083 -1.23Industry Q -3.632 -2.87† -3.380 -2.69*Corporate director -1.207 -3.20†Bank director -0.183 -0.42

R2 = 0.03; F = 3.67†; Obs = 684

R2 = 0.05; F = 4.21†; Obs = 684

†p < 0.010, *p < 0.050.

310 CORPORATE GOVERNANCE

© Blackwell Publishing Ltd 2005Volume 13 Number 2 March 2005

lasting almost 10 years. Many Japanese firmsdid not have sufficient cash flow to engage inmeaningful diversification and thus Japanesefirms under the control of the banks did nothave the resources to increase the level ofdiversification even if they had the intentionsto do so.

Finally, we note that the data did not pro-vide any support for the relationship betweenbank ownership and bank nominee directorsin Japan. In hindsight, this may be attributedto the fact that Japanese banks tend to senddirectors to their investee firms only duringperiods of financial distress (Sheard, 1994).Such “rescue” operations do not result in apermanent appointment of such directors andare usually reversed when the situation hasbeen stabilised. Therefore, although a bankmay have ownership, these equity risks aresmall relative to their debt exposures, the lat-ter of which are likely to be secured by collat-erals and legal covenants that work toattenuate the need for ongoing representationin the boardroom. Further, the globalisation ofthe capital market, and declining ability of theJapanese banks to rescue troubled client com-panies have made the commercial bankingrelationship more arm’s length and less rela-tional, with the result that banks may havebecome less inclined to be involved with theirclient firms’ management.

Overall, our model seems to suggest thatJapanese corporations holding equity in otherfirms are just as interested in efficiency, fromthe standpoint of strategic diversification, inthe use of resources as other financially driveninvestors. The difference is that they have theability to nominate directors that have a directinfluence on their investee firms’ strategies.This study also suggests that we have to payparticular attention to the institutional contextin which investors make their decisions. Weshow that the identity of the investor is animportant consideration for future studiesbecause bank and corporate owners in Japanseem to have different preferences for boardcomposition and strategy choice.

On a practical level, this study suggests thatbecause nominee directors in large Japanesecorporations see themselves representingspecific interests, investors would be wise topay attention to the composition of the boardin order to assess the level of protection theycan expect to receive as owners. Even with-out any apparent agency problem betweenmanagement and shareholders, there remainsa potential “principal-principal” or share-holders’ conflicts of interest problem. Theseconflicts can lead to the inefficient allocationof resources. This is particularly true of com-panies in Japan and other countries (e.g. con-

tinental Europe and Asia) where dominantshareholders are common.

Finally, we note a couple of interestingopportunities for future research. First, itwould be instructive to document whetherminority shareholders care about the presenceof nominee directors in the Japanese board-room. Increasingly, these minority share-holders are foreign institutional investorssuch as CalPers (California Public EmployeesRetirement System) and major fund manage-ment companies. The relationship betweenthese foreign investors are more likely to bearm’s length rather than relational. Thus, wewould expect the increase in minority owner-ship to result in a systematic discount, equalto the potential for expropriation by nomineedirectors that represent majority interests, ofthe share price.

We can also expand the categories of insti-tutional investors, for example by sub-classifying “market investors” into “retail”,“mutual”, “insurance”, “pension” and so on,to assess the impact of investment horizon onstrategy preferences. Standard CAPM theorysays that the relationship between risk/returnpreferences should be reflected in the stockportfolio that investors choose. However,large Japanese and foreign corporate investorsthat have commercial relationships with theirinvestee firms cannot exercise those choicesfreely because the movement of large blocksof shares will affect the value of the company.Thus, these investors may be forced to exercisetheir strategic preferences by direct action inthe boardroom so that a Japanese firm’s strat-egy may be the result of board compositionrather than that of a rationally driven eco-nomic decision-making process.

Acknowledgements

This research has been supported by aWharton-SMU Research Center Grant andthe Broadbent Endowment for Research at theLally School of Management and Technology.We would like to thank the Editor and twoanonymous reviewers for their careful readingand comments on earlier drafts of the paper.

Notes

1. Exceptions include Suzuki and Sho (2000).2. Similar situations exist in other parts of the

world. In Germany, for example, the Aufsichsrator supervisory board is not chosen for its strictcommitment to shareholder interests. Instead,bankers, unions and affiliate firms often have aninfluence through their director appointments.

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3. Defined, according to Jensen (1986), as free cashflow or the cash from operations and invest-ments net of contractual obligations and futureprojects with positive net present values.

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© Blackwell Publishing Ltd 2005Volume 13 Number 2 March 2005

Toru Yoshikawa is an associate professor ofmanagement in the School of Business atthe Singapore Management University. Hereceived his PhD from York University inToronto. His research interests include variouscorporate governance related issues, such aschanging governance practices of Japanesefirms, corporate governance of small- andmedium-sized enterprises, and role of venturecapital firms in corporate governance of ven-ture firms. He has published papers on corpo-rate governance and business strategy insuch academic journals as Asia Pacific Journalof Management, European Management Journal,Advances in International Comparative Manage-ment, Journal of Asian Business and Journal ofBusiness Venturing.

Phillip H. Phan received his PhD from theUniversity of Washington and holds theWarren H. Bruggeman ‘46 and Pauline UrbanBruggeman Distinguished Chair in the LallySchool of Management and Technology atRensselaer Polytechnic Institute, Troy, NY,USA. He has published in such journals asJournal of Business Venturing, Journal of Manage-ment, Academy of Management Journal, CorporateGovernance: An International Review, EuropeanManagement Journal and Asia Pacific Journal ofManagement. He serves on the editorial boardsof the Academy of Management Journal, theJournal of Business Venturing and the Journal ofFinancial Stability.

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