Presence of Outside Directors, Board Effectiveness and Firm

Performance: Evidence from Japan

Takuji Saito
a
*

September, 2009

a
Faculty of Economics, Kyoto Sangyo University, Kamigamo, Kita-ku, Kyoto 603-8555, Japan

Abstract
This paper examines whether the presence of outside directors affect the board
effectiveness and firm performance by studying the board of directors in Japan, where
many firms have recently introduced outside directors into all-insider boards. These
introductions allow us to econometrically compare the effects of board with outside
directors to those without. We find that introductions of outside directors into all-insider
boards significantly improve operating performance and firm value. In addition, we find
that when the firm has at least one outside director on the board, president turnover is
more sensitive to firm performance and management earnings forecasts are more
realistic and accurate. These results suggest that the presence of at least one outside
director on the board is effective in monitoring and advising managers.

JEL Code: G32; K22
Keywords: Board composition; Outside directors; Corporate governance

I would like to thank Kotaro Inoue, Katsuyuki Kubo, Hideaki Miyajima, Shin-ichi
Hirota, Yuji Honjo, Hideaki Kato, Akira Ishii and the seminar participants at the 2009
Nippon Finance Association meeting, the 2009 Japanese Economic Association meeting
and RIETI. This research was partly financed by the Japan Society for the Promotion of
Science through the grant in aid for scientific research #21730266. Needless to say, I am
solely responsible for any remaining errors.
* Faculty of Economics, Kyoto Sangyo University, Motoyama, Kamigamo, Kita-ku,
Kyoto 603-8555, Japan
E-Mail: tsaito@cc.kyoto-su.ac.jp
Tel/Fax: +81-75-705-1761
1
1. Introduction
The board of directors of a corporation is one of the most important corporate
governance mechanisms that help to solve the agency problems inherent in managing an
organization characterized by the separation of ownership and control. Generally, the
boards are composed of inside and outside directors. Both directors have a fiduciary
duty to shareholders. But, the outside directors are expected to represent shareholders
interest, because inside directors may not feel compelled to contradict the top managers
whose preferred projects are not always those that maximize firm value. Over the past
few decades a considerable number of studies have been made on how outside directors
affect the effectiveness of the board of directors and firm performance. As a result, our
understanding of the role of the board and outside directors is rapidly expanding.
However, the outside director literature has largely developed in the U.S., where most of
firms have boards with many outside directors. Given that all corporations have outside
directors, it is impossible to compare the effects of the boards with outside directors to
those without econometrically as there is no variation in the explanatory variable.
Therefore, there has been no study that tried to answer the simple but fundamental
questions: How effective is the board with outside directors compared to the board
which is entirely composed of inside directors? What is the impact of introduction of
outside directors into all-insider board?
In this study, we try to fill this gap by studying the board of Japanese firms. Recently,
corporate governance reforms have been enacted in many countries to seek to increase
board independence. Similar tendency was observed in Japan. Traditionally, most of
Japanese public firms did not have outside directors on their boards. In 1996, about 80
percent of our sample firms had all-insider board. But, the corporate governance reform
movement began in response to the decline in corporate performance and escalating
2
number of corporate scandals after 1997. In response to these movements and the
amendments of the Japanese Commercial Law, many firms have introduced outside
directors to their all-insider boards. On average (median), 1.5 (1) outside directors have
been introduced into the board composed of 12 (10) inside directors. As a result,
one-half of the firms have at least one outside director on their boards in 2007. This
setting is markedly different from that in other countries such as U.S., where public
companies have changed their board structure in response to their environment for many
years (Lehn, Patro and Zhao, 2009).
These introductions in Japan afford a unique opportunity to identify the effects of the
presence of outside directors on firm performance and board effectiveness. We can
econometrically compare the firms with outside directors to those without. Using the
sample of 483 largest companies in Japan during 1996-2007, we find that the
introductions of outside directors into all-insider boards significantly improve firm
performance, though previous studies could not find the significant relationship between
board composition and firm performance (Hermalin and Weisbach, 1991; Black and
Bhagat, 2002). First, we study operating performance (OROA) changes following the
introductions. We find that the operating performance significantly increases after
outside directors first join all-insider board. However, we could not find the significant
improvements when outside directors are added to the board which already have outside
directors. These findings are robust to controlling for the systematic differences in firm
characteristics between introduction and non-introduction firms by using
difference-in-difference propensity score matching estimators. Second, we study market
reactions to announcements of the introductions of outside directors. We find that the
investors reaction to the introductions is significantly positive. For example,
cumulative abnormal return over the five-day period surrounding the announcements is
3
about 1.3%. Over the same period, cumulative abnormal return surrounding the
announcements of appointments of additional outside directors is about 0.45%, but not
significant. These patterns persist when we examine abnormal returns in a two-stage
frame-work that accounts for the prior anticipation of such announcements. In addition,
these improvements in operating performance and firm value are robust to controls for
the number of introduced outside directors and banker outside directors.
Given these results, we then address the important question of how the introduced
outside directors improve firm performance. The primary role of the board is to monitor
and provide advice to top management. Therefore, we study the effects of the presence
of outside directors on board monitoring and advisory role.
To examine whether the presence of outside directors affects monitoring role of the
board, we analyze the relationship between firm performance and president turnover.
The sensitivity of top manager turnover to firm performance may be considered a
measure of the intensity of board monitoring. We find that the presence of at least one
outside director on the board is significantly effective in monitoring and disciplining
managers. Probability of president forced turnovers increases significantly following the
firms low industry-adjusted operating performance. This relation is significantly
stronger for firms with outside directors than for those without. In addition, this
relationship still remains, even when the board includes only one outside director. This
result may be complementary to the finding of Weisbach (1988) that CEO turnover is
more sensitive to firm performance when a majority of directors are outsiders than when
a majority are insiders.
To examine whether the presence of outside directors affects advising role of the
board in setting strategy, we analyze the precision of management forecasts. In Japan,
managers are required to prove annual forecasts at the beginning of the fiscal year. Thus,
4
we can investigate how the presence of outside directors affects managers forecasts
without the endogeneity problem that arises when forecast disclosure is voluntary.
Consistent with Kato, Skinner and Kunimura (2009), we find that managers annual
sales and earnings forecasts are, on average, optimistic. But, they are more optimistic
when board is composed solely of inside directors than when board includes at least one
outside director. This result suggests that advice from outside directors help managers to
make more realistic and accurate forecasts.
Overall, our results suggest that participation of at least one outside director in the
board is significantly more effective in monitoring and advising managers than no
participation at all. Thus, introduction of at least one outside director into all-insider
boards could improve firm performance.
The structure of the paper is as follows. In the next section, we review the
institutional details of board of directors in Japan and present our hypothesis. We
explain the data and variables in Section 3. The effect of introduction of outside
directors on operating performance and firm value will be investigated in Section 4. In
Section 5, we analyze the effect of the presence of outside directors on monitoring and
advisory roles. In section 6, we conclude the paper.

2. Background
2.1 Board of Japanese firms
Legally, the corporate board system in Japan resembles that of the U.S
1
. A public
company is required to have three or more directors
2
. The board of directors had the

1
For details of corporate governance in Japan, see Hoshi and Kashyap (2001) and Fukao
(1995).
2
Differently from U.S., Japanese firms were required to have three or more auditors
(Kansa-yaku) and to have a board of the auditors. The principal duty of auditors was to
5
power to adopt resolutions on important matters concerning the affairs of the company,
including the appointment of any executive directors (including president or CEO). In
addition, the board of directors supervised the activities of the management directors
(Company Law, Article 362). However, the composition of the board of Japanese firms
is totally different from that of U.S. firms. A majority of Japanese public corporations
have insider-dominated boards or all-insider boards, which is comprised of senior
managers who have served the corporation throughout their careers
3
. For example,
Toyota Motor Corporation had 9 executive directors, 21 non-executive inside directors,
and no outside directors in 2008. 19 of 21 non-executive directors were division heads.
Two other directors were previous presidents. Surprisingly, 29 of 30 directors had
worked at Toyota since their graduation. Figure 1 shows the ratio of the firms with at
least one outside director, and Figure 2 shows the ratio of the firms classified by the
number of outside directors on their boards in our sample
4
. In 1996, 80 percent of large
public firms in Japan had all-insider boards. Furthermore, only 3 percent of firms have
more than three outside directors on their boards. Because of these features, it is argued
that boards of directors in Japan fail to monitor adequately the firms president and
management directors since presidents and inside management directors face little or no
pressure from outside directors.
In 1997, the corporate governance reform movement began in response to the decline

monitor the boards compliance with law and to review the financial statements. They
lack the authority to appoint or remove directors and presidents (CEOs).
3
Kaplan and Minton (1994) and Morck and Nakamura (1999) indicate that
bank-dispatched directors play an important role in the governance of Japanese firms.
Most of these directors are not outsider, because they have quit banks and are fully
employed by the firm. Saito and Odagiri (2008) show that bank-dispatched directors
contribute to firm performance through their participating in management.
4
Details of sample firms are provided in section 3.
6
in corporate performance and escalating number of corporate scandals
5
. Sony first
introduced U.S. style board system by reducing the size of its board, and increasing the
number of outside directors. The Japanese Pension Fund Association, which is one of
Japans largest pension funds, has adopted the proxy voting guidelines under which the
board of the public companies should have outside directors. The Commercial Code
amendments were proposed to improve the monitoring mechanisms in Japanese public
corporations by mandating outside directors on boards. However, the Federation of
Economic Organizations
6
(Keidanren) strongly opposed this mandating rule
7
on two
grounds: outside directors were not well suited to perform useful role in highly
relational Japanese corporate affairs; finding suitable outside directors would be
difficult given the lack of experience with the practice. As a result, the enacted amended
Commercial Code in 2002 did not mandate outside directors for all firms. Instead, it
reduced the personal liability of outside directors, and allowed to adopt U.S. style
committee system
8
instead of auditor system in order to encourage having more
outside directors. In response to these movements, many firms have for the first time
appointed outside directors to their all-insider boards. Figure 1 shows that about 30
percent of the sample firms introduced outside directors during 1996 to 2006. Figure 2
shows that ratio of firms with more than 3 outside directors also increase by about 10

5
For details of corporate governance reform in Japan, see Aoki, Jackson and Miyajima
(2008) and Gilson and Milhaupt (2005). Kato, Lemmon, Luo and Schallheim (2005)
analyze the adoption of stock option plans which was prohibited before the revision of the
Commercial Code in 1997.
6
Federation of Economic Organizations is the most influential business association in
Japan. They have made large political donations to Liberal Democratic Party. They are
managed by incumbent top managers of member firms.
7
U.S. government came out in favor of this mandating rule. (The Nikkei, 18 June, 2001)
8
Adopting firms could abolish the board of auditors and establish committees of the
board for nomination, audit and compensations. Each committee must have at least three
members, a majority of whom are outside directors.
7
percent during same period. However, half of the firms have still not had outside
directors on their boards. Only six firms have outsider-majority boards in our sample.

2.2 Hypothesis
Most directors can be classifies as insider directors or outside directors. Inside
directors are employees or current managers. They are not thought to be independent of
the top managers, since the success of their careers is often tied to the top managers
success. In contrast, outside directors are not employees of the firm. They are thought to
monitor and, if necessary, discipline the top managers, since they are independent of
management. Therefore, a large number of studies have been made on how outside
directors affect the effectiveness of the board of directors and firm performance.
Bhagat and Black (1999) , Hermalin and Weisbach (2003) and Adams, Hermalin and
Weisback (2009) provide excellent and extensive surveys of prior studies of the
relationship between board composition and corporate decisions and performance. Thus,
our review of this literature will be brief.
The outside director literatures have largely developed in the U.S., where most of
firms have boards with many outside directors. Given that all corporations have outside
directors, the literature devotes a great deal of attention to the ratio of outside directors
to total directors. Rosenstein and Wyatt (1990) show that the additional appointment of
outside directors is positively related to market reaction. However, other studies report
insignificant relationship between firm performance and the fraction of outside directors
on the board (Hermalin and Weisbach, 1991; Black and Bhagat, 2002)
9 10
. Several

9
Several studies show how an outsider-dominated board affects various tasks,
including firing of the CEO (Weisbach, 1988), adoption of anti-takeover devices
(Brickley, Coles and Terry, 1994), and negotiating takeover premiums (Byrd and
Hickman, 1992; Cotter, Shivdasani and Zenner, 1997).
8
recent theoretical and empirical studies of board structure help to understand why the
relationship between firm performance and board composition is insignificant. The
theoretical studies suggest that the composition of the board is endogenously
determined based on a firms characteristics and operating environment (Hermalin and
Weisbach, 1998; Raheja, 2005; Adams and Ferreira, 2007; Harris and Raviv, 2008).
Consistent with these theoretical studies, recent empirical studies (Boone, Field,
Karpoff and Raheja, 2008; Coles, Daniel and Naveen, 2008; Linck, Netter and Yang,
2008) find that U.S. firms structure their boards in ways consistent with the costs and
benefits of monitoring and advising by the board. Especially, Lehn, Patro and Zhao
(2009) study 81 firms that survived from 1935 to 2000 and show that board structure of
U.S. firms has been determined endogenously for many years.
These settings in U.S. are totally different from those in Japan, where many firms
have had all-insider boards for a long time and recently introduce outside directors.
Thus, an advantage of the Japanese setting is that we can examine the initial decision to
have outside directors on boards and compare the board with outside directors to those
without.
We presume that the effectiveness of the board with outside directors in monitoring
and advising management might be significantly different from that of all-insider boards.
To maximize firm value, the board of directors is obliged to reject the bad projects
which enhance managers welfare, but reduce shareholder value, and adopt the good
projects which create firm value even if they reduce managers welfare. However, when
the board is composed entirely of inside directors, no one might challenge, question,
probe, discuss and test the corporate plans and strategies submitted by the managers in

10
Some recent studies find the positive association between the board composition and
firm performance by analyzing the effects of the regulation changes (Dahya and
McConnell, 2007; Choi, Park and Yoo, 2007).
9
the boardroom. As a result, managers could easily obtain approval of the board, even
when they would submit the self-interested pet projects. In this way, we can predict that
all-insider boards rarely provide monitoring and supervisory functions.
On the other hands, the board with outside directors could provide effective discipline
for the managers. In contrast with insiders, outside directors could challenge, question,
probe, discuss and test the corporate plans and strategies submitted by the managers in
the boardroom. Managers are needed to give an acceptable explanation of the project for
the questions from outside directors who represent the interest of shareholders. Thus,
the presence of outside directors on board might discourage managers from submitting
the bad project which cannot be explained to the satisfaction of the shareholders.
But, managers and insiders could force their preferred projects simple by voting as a
block and ignoring outside directors, when the board is dominated by insiders. If this is
the case, the board with a minority of outside directors, similarly with all-insider boards,
could not provide effective discipline for the managers. This argument is applied to the
most of Japanese public firms, which we analyze below.
However, the experimental researches on dictator games imply that even minority
outsider participation is somewhat effective in controlling managerial opportunism.
Situation of insider-dominated board where managers and insiders could control the
voting is similar with that of the dictator game. The dictator game models the
interaction of two players, the dictator and the recipient. The dictator is asked to allocate
a fixed amount of money between himself and the recipient, deciding unilaterally about
the allocation of the money. Following the game theoretic predictions, self-interested,
nonsatiated dictator will take all money, leaving nothing for the recipients. But, the
results of the experiments in dictator games are generally not consistent with the game
10
theoretic predictions
11
. They find that dictators often allocate money to the recipients,
reducing the amount of money they receive (Kahneman, Knetsch and Thaler, 1986;
Forsythe, Horowitz, Savin and Sefton, 1994). In addition, several papers show that these
deviations from theoretical predictions are sensitive to the decision making environment.
For example, Bohnet and Frey (1999) demonstrate the role of identification and social
distance on allocations. They find that when participants are able to identify one another,
dictators tend to allocate more money to the recipients
12
. Yamamori, Kato, Kawagoe
and Matsui (2008) demonstrate the role of the recipients voice on allocations. They find
that the dictators offer increases as the recipients request increases up to the fair
division, but decreases as the recipients request increases more than fair division.
Following these results of the experimental studies of dictator games, managers
would act in the interest of the shareholders even by reducing their welfare, when they
identify the shareholders more strongly and receive the shareholders request in the
decision making process. Dispersed shareholders could not intervene the decision
making process. But, outside directors who represent the interest of shareholders could
participate in the board of directors, help managers identify the interest of shareholders,
and give voice to shareholders request, even when they are a minority. Therefore, we
can predict that even minority outsider participation is somewhat effective in preventing
managers from pursuing their own interests at the expense of shareholders. The results
of Gillette, Noe and Rebello (2003, 2008), which experimentally examine the
relationship between board structure and performance, confirm these predictions.
Gillette, Noe and Rebello (2003) find that consistent with the game theoretical

11
Bolton, Katok, and Zwick (1998) provide an overview of early dictator game
experiments.
12
Hoffman, McCabe, Sacchat and Smith (1994) find dictators tends to allocate very
little under the double-blind condition.
11
prediction, all-insider boards almost always choose inefficient self-interested policies.
But, Gillette, Noe and Rebello (2008) find that contrary to the game theoretical
prediction, even minority representation of outside directors reduce opportunistic
behavior by insiders and frequently produced value-maximizing outcomes.
In addition to the monitoring role, board of directors may play an advisory role in
setting strategy. The advice provided by directors could affect the quality of the strategy
and projects. But, the advice provided by outsiders should be distinct from that by
insiders, because inside and outside views draw on different sources of information, and
apply different rules to its use (Kahneman and Lovallo, 1993; Lovallo and Kahneman,
2003). An inside view is generated by focusing on the abilities and resources of a
particular group, constructing scenarios of future progress, and extrapolating current
trends. In contrast, an outside view ignores the details of the case at hand, constructs a
class of cases similar to the current one, and guesses where the current cases lies in that
class. As a result, Kahneman and Lovallo indicate that the inside view is much more
likely to yield an optimistic forecast, but outside view is much more likely to yield a
realistic forecast. Following these arguments, outside directors could be more likely
than inside directors to provide accurate and realistic forecasts to managers. Therefore,
we can presume that managers could formulate more realistic and accurate strategy and
project, when they could receive the advice from outside directors. But, managers might
formulate optimistic and unrealistic strategy and project, when they receive the advice
only from inside directors.
Overall, we could presume that the board with outside directors, even if they are a
minority, plays more effective role in monitoring and advising management than
all-insider boards. Therefore, we hypothesize that the introductions of outside directors
into all-insider boards could improve the firm performance by reinforcing the
12
monitoring and advisory role of the board.

3. Sample and data
Our data set is a panel of 4,839 firm-year observations of 483 Nikkei 500
13
firms
listed in Tokyo Stock Exchange during the period 19962006. The sample includes all
the firms that were in the Nikkei 500 in any of these years; are not subsidiary firms
(with 15% or more owned by another firm)
14
; and whose primary industry is not
financial services. For those firms that meet these criteria, we include all years with data
available between 1996 and 2006, even if the firm is not in the Nikkei 500 list in a
particular year. As a result, our data set represents the most important public companies
in Japan during the sample period. While this screening process tends to favor large
firms, this data set enables us to mitigate the short supply problem which is caused by
immature market for outside directors in Japan. If the short supply of outside directors is
the main determinants of board structure, our results are highly biased, because our
analysis focus on the demand side factors which affects the decision to introduce
outside directors. This problem could be more serious for small firms.
The information on the companies directors and presidents was taken from Yuka
Shoken Hokokusyo [Japanese 10k] and Yakuin Shikiho [Directory of Directors]
published by Toyo Keizai Shinposya. This directory reproduces the names and titles of
all the directors of public companies in Japan, as well as their previous and concurrent
positions inside or outside of the firm, as reported in the company statements. We use

13
The Nikkei 500 is an index of the largest 500 shares traded on the 1st section of the
Tokyo Stock Exchange.
14
Subsidiary firms are likely to be subject to different governance mechanisms. We
exclude 160 subsidiary firms from our sample. If the sample firms changed into
subsidiary firms during the sample period, we exclude these firms from the sample at the
time.
13
this information to determine whether each director is outside director or not. Outside
director is defined in Japanese Commercial Code as a director who does not execute the
affairs of the company; who in the past has never occupied the position of director,
executive officer, manager or any other employee who execute the affairs of the
company or its subsidiaries; and is not a manager or any other employee of the company
or its subsidiaries.
The definition of firm characteristic variables and performance measures are
explained at Table 1. All control variables except risk are obtained from The Corporate
Financial Databank, compiled by the Development Bank of Japan. Risk is calculated
using the Kabuka CD-ROM (published by Toyo Keizai Shinposya). We winsorize all
variables at the 1st and 99th percentile values.
The left three columns in Table 2 provide the means, standard deviations and medians
for the variables for all sample observations. The median firm in our sample has sales
of 271 billion yen ($2.71 billion), although the median firm in all listed firms during
sample period has sales of 43 billion yen. This difference shows that our sample
includes relatively large firms. Columns 4 to 6 provide the means, standard deviation
and medians for the firms with outside directors. Columns 7 to 9 provide the means,
standard deviation and medians for the firms without outside directors.
The last two columns show the results of difference of means and medians tests
between the firms with and without outside directors. We find that there are significant
systematic differences in many characteristic variables between the firms with outside
directors and those without. The mean and median sales of the firms with outside
directors are significantly larger than that of the firms without outside directors. In
addition, the firms with outside directors have more business segments and affiliated
firms. The firms without outside directors have higher return variance. These significant
14
systematic differences may indicate that decision to introduce outside directors may be
not random, but be related to various firm characteristics.

4. The impacts of introductions of outside directors on firm performance
To identify the causal effects of the presence of outside directors on firm performance,
we study the operating performance change following introductions of outside directors
into all-insider boards and market reactions to the announcements of the introductions.
We find 144 introductions of outside directors in our sample. For comparison, we also
study the effects of increasing the number of outside directors. Our increasing event is
defined as when the firm which already has outside directors on board appoints
additional outside directors. Therefore, our increased appointment of outside directors
does not include the introductions. We find 100 increased appointments of outside
directors in our sample. In 35 cases, the firms with one outside directors appoint one
additional outside director. In 24 cases, the firms with two outside directors appoint one
additional outside director. In 11 cases, the firms with one outside directors appoint two
additional outside directors. In only 5 cases, board is dominated by outsiders after the
increased appointments.

4.1 Operating performance changes following introductions of outside directors
Our basic strategy for estimating the effects of introductions of outside directors is to
compare operating performance before and after the introductions of them. An
advantage of using within-firm variation in performance is that it allows us to control
for time-invariant characteristics that might jointly affect a firms future performance
and its decision to introduce outside directors. We evaluate operating performance using
operating income on assets (OROA). In the left side of Table 3, we report mean and
15
median changes in OROA following the introduction events
15
. We find the significant
increases in OROA following the introductions of outside directors. After introductions,
the mean (median) change in OROA from year -1 to year +2 is 1.1% (0.88%) and
statistically significant. The mean and median changes from year -1 to +3 are also
positive and significant. However, we could not find significant changes from year -1 to
year 0 which show the pre-introduction performance change. This result shows that the
improvement of the operating performance is not explained by the pre-event trends.
Lower panel of Table 2 show the mean and median changes in OROA around the
increasing the number of outside directors
16
. In contrast with the results of the
introductions, we cannot find the significant changes in OROA after the increased
appointment of outside directors.
The improvement in OROA from before to after introduction is consistent with our
hypothesis. But, many previous papers show that changes in unadjusted OROA is
strongly affected by macroeconomic trends, industry trends and previous firm
performance. Hence, the performance improvements we find could be due to the trends
and potential mean-reversion of the accounting performance rather than to introductions
of outside directors. To control for time trends, industry trends and potential
mean-reversion, we adjust OROA using performance-matched method advocated by
Barber and Lyon (1996)
17
. In the right side of Table 3, we report mean and median

15
The sample size declines with time, because data subsequent to year 0 is unavailable
for recent appointments.
16
We exclude the increased appointments which followed the introductions or other
increased appointments within previous three years.
17
Each sample appointment is matched to comparison firms with same two-digit
industry code whose OROA one-year before the appointments is within 10% of the
samples OROA. If there are not such firms, we match OROA within the 10% filter
using all firms with the same one-digit industry code. For firms without matches after this
procedure, we use all firms with OROA within the 10% filter bounds regardless of
industry code. Each samples OROA is adjusted by subtracting the median OROA of its
16
changes in industry- and performance-adjusted OROA from before to after the
introductions of outside directors and increased appointments. We find that significant
improvement following introductions still remains after controlling the year and
industry trends and mean-reversion. The mean change in industry- and
performance-adjusted OROA from year -1 to year +1 is 0.45 and statistically significant.
The mean changes from year -1 to year +2 and year +3 is also positive and significant.
However, we cannot find the significant changes in adjusted OROA around increased
appointments. Apparently, the increase in profitability for firms that introduce outside
directors is not due solely to macroeconomic factors, industry trends and
mean-reversion that influenced all firms profitability.
In Japan, public companies can choose to have or not have outside directors on the
board, because amended Japanese company law does not mandate outside directors. If
the decision of the introduction is not a random but is related to various firm
characteristics, our prior analyses that assumes introductions are exogenous may
produce a biased estimate of the effect of introductions. In fact, the results of univariate
test in Table 2 show that there are significant differences in many firm characteristics
between the firms with outside directors and those without. Therefore, the improvement
of operating performance following the introductions of outside directors might be
caused by these differences of firms characteristics between the introduction and
non-introduction groups. To cope with this problem, we select matching firms with
similar ex ante firm characteristics from non-introduction firms using propensity score
matching method (Rosenbaum and Rubin, 1983; Rosenbaum and Rubin, 1985;

comparison group. Changes over time in adjusted OROA are then calculated. The
comparison firms are chosen from all listed firms which are included in The Corporate
Financial Databank, compiled by the Development Bank of Japan.
17
Heckman, Ichimura and Smith., 1997; Heckman, Ichimura, Smith and Todd, 1998)
18
.
The propensity score is the conditional probability of treatment assignment given ex
ante variables, such as the probability of introduction of outside directors given firm
characteristics. Therefore, the propensity score method enables us to find suitable
matches, even if there are differences in multiple dimensions between the treatment and
non-treatment groups. For each introduction, we pick the non-introduction firm that has
the closest propensity score within the same year (and same two-digit industry) to be the
match. The propensity score is calculated using a logit regression analysis of the
determinants of introduction
19
. Making use of this result, we conduct propensity score
matching and compare the performance of introduction firms to that of matched
non-introduction firms. If the selected matching firm introduces outside directors in
post-three years, it is dropped and the firm with the next closest propensity score is used
as the substitute matching firm.
For each increased appointment, we pick the non-appointment firm that has same
number of outside directors
20
and has the closest propensity score within the same year
(and same two-digit industry) to be the match. We estimate propensity score off a logit
model for the decision to increase the number of outside directors. If the selected
matching firm appoints additional outside directors in post-three years, it is dropped and
the firm with the next closest propensity score is used as the substitute matching firm.
Table 4 and 5 presents the results of propensity score analysis and matching quality of

18
Dehejia and Wahba (2002) discuss propensity matching method in detail. Villalonga
(2004) examine whether the discount of diversified firms can be attributed to
diversification using this method.
19
Refer to Appendix A for more detailed explanation and results of the analysis of
determinants of introductions and increasing the number of outside directors.
20
We have small number of firms with over three outside directors. Therefore, we match
the increased appointments by the firm with over three outside directors with the
non-appointment firm with over three outside directors.
18
ex ante firm characteristics. Panel B of Table 4 reports differences in mean ex ante firm
characteristics between introduction and non-introduction matched by propensity scores.
We only show the propensity score and important variables which have significant
effect on the decision to introduce or increase outside directors. It is seen from Panel B
that the ex ante variables are well balanced between the treatment and control groups.
When we pick the non-introduction firm that has the closest propensity score within the
same year to be the match, there are no significant differences in any variables between
the treatment and control groups. Therefore, our propensity score matching is able to
balance ex ante variables simultaneously, implying that there is no treatment effect
introduced by firm characteristics.
Panel A of Table 4 report the average and median changes in industry- and
performance-adjusted OROA of introduction firms and matching firms and difference in
the changes between introduction and matching firms. The results of propensity
matching method confirm our previous results that introductions of outside directors
improve operating performance. When we match each introduction with the firms that
has the closest propensity score within the same year, the estimated average differences
in changes in adjusted OROA from year -1 to year +2 and year +3 are 0.90 and 0.86,
and significant at conventional level. Median differences are also positive and
significant. In addition, the estimated difference-in-differences in changes from year -1
to year 0 cannot be distinguished from zero at conventional levels of statistical
significance. These results suggest that the operating performance of treatment and
control firms were following similar trends before treatment, but they diverge after the
treatment. When we select the control sample from the firms which are within the same
year and two-digit industry of each introduction, we also find the significant positive
differences in changes in adjusted OROA between the introduction firms and their
19
control groups. These results suggest that introduction firms exhibit significantly greater
improvements in operating performance as compared to non-introduction firms with
similar characteristics
21
.
Table 5 shows the results for the effect of increasing the number of outside directors.
Panel B shows that there are no significant differences in any variables between the
treatment and control groups, when we pick the control firm that has the closest
propensity score within the same year to be the match. This suggests that our matching
procedure has succeeded in selecting control firms in a manner that balance ex ante
variables between treatment and matching firms. However, we could not find the
significant improvements of operating performance after increasing the number of
outside directors. Panel A shows that all difference in changes in adjusted OROA
between increased appointment groups and matching groups are not significant at
conventional level.
We explore the robustness of our operating performance results. Following
Wooldridge (2002, Chapter 18), we regress the outcome on treatment, covariates (the
variables determining the occurrence of the treatment), and interactive terms between
the treatment and covariates. This method allows us to estimate not only the average
treatment effects, but also how the treatment effects change for various levels of
covariates. Recent theoretical studies (Raheja, 2005; Adams and Ferreira, 2007; Harris
and Raviv, 2008) presume that information cost affect the functioning of outside
directors and the board. Consistent with this idea, Duchin, Matsusaka and Ozbas (2009)
find that firm performance worsens when outside directors are added to the board and

21
In order to improve the quality of the matches, we impose the common support
condition (Heckman, Ichimura and Todd, 1997). The common support region is bounded
between the minimum propensity score for appointment firms and maximum propensity
score for non-appointment firms. When we exclude the samples out of this region, the
results are almost similar.
20
information costs are high. Following these studies, the effect of introduction of outside
directors on performance may depend on their cost of acquiring information: the proxy
variable for information cost may have significant interaction with the effect of
introduction on subsequent performance.
Following Linck, Netter and Yang (2008), our proxy variables for information cost
are Risk, R&D, and MTB employed in the analysis of determinants of introductions
shown in Table A1. But, if we include all covariates appeared in the analysis of
determinants of introduction simultaneously, we may encounter a serious
multi-collinearity problem. In order to mitigate a multi-collinearity, we use principal
components analysis which could increase the power of the multivariate analyses by
circumventing difficulties arising from multi-collinearity. We combine proxy variables
for complexity, information costs and the private benefits and create three new proxy
variables, COMPLEX, INFOCOST and PRIBENEFIT. COMPLEX is the principal
factor considering the information contained in the log of Sales, the log of Segments,
Affiliated firm, and Foreign sales. INFOCOST is the principal factor considering the
information contained in Risk, R&D, and MTB. PRIBENEFITS is the principal factor
considering the information contained in FCF and Industry OROA. The equation to be
estimated is as follows.

Cbongc in inJustry oJ]ustcJ 0R0A = [
1
+[
2
IntroJuction Jummy
+ [
3
IntroJuction Jummy C0HPIEX +[
4
IntroJuction Jummy
INF0C0SI + [
5
IntroJuction Jummy PRIBENEFII
+ [
6
IntroJuction Jummy Iog(Forcign sborc) +[
7
C0HPIEX
+[
8
INF0C0SI + [
9
PRIBENEFII + [
10
Iog(Forcign sborc)
+ [
11
inJustry oJ]ustcJ0R0A
21

The sample is composed of the firms with all-insider board. In order to control
industry trends, we use industry-adjusted OROA which is defined as OROA minus
industry median OROA. We define Change in industry-adjusted OROA as the change in
industry-adjusted OROA from year -1 to year +1, +2 or +3. In order to separate the
mean-reversion effect from the treatment effect, we add the past performance variable
(industry-adjusted OROA at year -1) as an explanatory variable. Because our data set
consists of a cross-sectional time-series panel, we control for lack of independence
among observations from the same firm by estimating OLS regressions with clusters
based on firms
22
.
The results are shown in Table 6
23
. In all the equations, the coefficients of
industry-adjusted OROA, are negative and significant, confirming the presence of mean
reversion; that is, firms with a relatively low profitability tend to experience an
improvement in performance whether introduction takes place or not. Consistent with
the results of propensity score matching methods, the estimated coefficient of
introduction dummy is significantly positive for changes in industry-adjusted OROA
from year -1 to year +2 or +3. That is, if the firms currently having all-insider board
introduce outside directors, they improve their performance relatively to the firms
without the introductions, conditioning on the covariates that affect the probability of
introduction. We thus confirm that the introduction of outside directors indeed
contributes to the improvement of performance.
Inconsistent with Duchin, Matsusaka and Ozbas (2009), the interactive terms

22
Petersen (2009) provides a thorough discussion of potential solutions for dealing with
clustered standard errors.
23
We also analyze the effects of the increased appointments with similar manner. But, we
could not find significant results.
22
between introduction dummy and INFOCOST are not significant. These results suggest
that the effect of introduction of outside directors on performance does not depend on
their cost of acquiring information. This difference may be attributed to the fact that U.S.
firms can choose and have chosen board structure to maximize firm value for many
years, but Japanese firms could not and had not chosen board structure.

4.2 The market reaction to introduction of outside directors
In this subsection, we analyze the market reaction to introductions of outside
directors. If initial outside directors improve the advising and monitoring role of the
board, we expect the market reaction to the announcements of the introductions to be
positive.
Table 7 shows the cumulative abnormal returns (CARs) around the announcement
dates. We identify the announcement dates using The Nikkei. The abnormal returns are
computed relative to a market model estimated over the period beginning 220 days prior
to the announcement date and ending 21 days prior to the announcement date. The
return on the Tokyo Stock Exchange TOPIX index is used as the market return. We
exclude the events which have confounding events such as mergers around the event
period
24
.
Panel A shows that the market reaction to introductions of outside directors is
significantly positive. The average CAR over the three-day window [-1, +1] around the
announcement date is 1.03% and significantly different from zero. The median CAR
over same window is 0.94% and the sign test rejects the hypothesis that the numbers of
positive and negative CAR are equal. The average and median CARs over the five-day
window [-2, +2] around the announcement date are also positive and statistically

24
We have similar results, when we include the excluded events in the sample.
23
significant. Thus, the market reacts positively to introduction of outside directors. For
comparison, we also estimate the CARs around the announcement date of increased
appointments. The lower line of Panel A shows the CARs around increased
appointments. In contrast with the results of the introductions, the mean and median
CARs around increased appointments are positive, but not statistically significant.
A potential problem with these CARs is that initial appointments are a partially
anticipated event. In order to control for such prior anticipations, we follow Kang and
Shivdasani (1996) and Shivdasani and Yermack (1999), and estimate the two-stage
CARs by dividing the observed CAR by one minus the predicted probability that the
firm introduces outside directors or appoints additional outside directors. The predicted
probability is calculated using a logit regression analysis of the determinants of
introduction and increasing the number of outside directors shown in columns (1) or (3)
of Table A1. Panel B in Table 7 reports the two-stage CARs around the introductions
and increased appointments. While these two-stage CARs are larger in magnitude than
the unadjusted CARs, the overall pattern is similar. For the introductions, the average
two-stage CAR over the three-day window [-1, +1] is 1.18% and statistically significant.
The average two-stage CAR over the five-day window [-2, +2] is 1.4% and also
statistically significant. In addition, the median two-stage CAR is positive and
significant. However, all CARs around increased appointments are not statistically
significant.

4.3 The effects of the number of appointed outside directors
In the previous subsection, we find that introductions of outside directors improve the
operating performance and firm value. However, we do not consider the number of
introduced outside directors. In section 2.2, we argue that the presence of outside
24
directors regardless of the number of them improve the effectiveness of the board. If
this is the case, we can predict that introduction of outside directors improve firm
performance, even if only one outside director is added to all-insider board. To test this
prediction, we divide introduction sample (144 events) into appointments of single
outside director (85 events) and appointments of multiple outside directors (59
events
25
).
Table 8 shows the average and median changes in adjusted OROA following the
appointments of single outside director and multiple outside directors. For the
appointments of single outside directors, the changes in operating performance
following the appointments are all positive and significant at 10 percent level. For the
appointments of multiple outside directors, only the change from year -1 to year +2 has
significant positive effects. However, all differences between appointments of single
and multiple outside directors are not significant at conventional level.
Similarly with the analysis of operating performance, we also estimate the market
reaction to the number of appointed outside directors. Table 9 shows the CARs around
the appointments of single outside director and multiple outside directors. We also could
not find the significant difference of CARs between appointments of single outside
director and multiple outside directors. The CAR over the three-day window [-1, +1]
around appointments of single outside director is 1.16% for the mean and 0.55% for the
median. The CAR over same window around appointments of multiple outside directors
is 0.83% for the mean and 1.09% for the median. The differences between these means
and medians are not significant at conventional level. Similar tendency was observed
regarding the CARs over five-day window [-2, +2]. Thus, the market reacts equally to

25
In 48 events, two outside directors are appointed. In 6 events, three outside directors
are appointed. Maximum number of appointed outside directors are five.
25
the appointments of single and multiple outside directors.
Overall, we find that operating performance and stock price is significantly improved
even after only one outside directors is introduced into all-insider boards. These results
might suggest that regardless number of outside directors, the presence of them on the
board could enhance the effectiveness of the board.

4.4 The effects of banker outside directors
In Japanese Commercial Code, banker can accept outside directorship of their
borrowers. Many previous studies show that main banks play an important monitoring
and disciplinary role in Japan (Aoki, Patrick and Sheard, 1994; Hoshi and Kashyap,
2001). Hence, the performance improvements we find might be due to introduction of
banker outside directors. To distinguish the effect of bankers, we divide introduction
sample (144 events) into appointments of non-bankers (120 events) and appointments of
bankers (24 events). Table 10 shows the average changes in adjusted OROA following
the appointments of non-bankers and bankers. For the appointments of non-banker, the
changes in operating performance following the appointments are all positive and partly
significant at 5 percent level. For the appointments of bankers, only the change from
year -1 to year +1 has significant positive effects. However, all differences between
appointments of non-banker and banker outside directors are not significant at
conventional level.
Similarly with the analysis of operating performance, we also estimate the market
reaction to the appointment of non-bankers and bankers. Table 11 shows the CARs
around the appointments of non-banker director and bankers. Average and median
CARs around the appointment of non-bankers are positive and significant at 1 percent
level. However, average CARs around the appointment of bankers are negative. In
26
addition, the difference in average CAR over the three-day window [-1, +1] between the
appointment of non-banker and banker is statistically significant. These results might
suggest that the investors consider that the bankers outside directors act in the interest of
creditors rather than shareholders. Overall, our results suggest that the improvement of
firm performance after introduction of outside directors is not dependent on the effect of
banker outside directors.

5. The presence of outside directors and board effectiveness
The analyses in section 4 show that the introductions of outside directors enhance the
operating performance and firm value. A question that occurs is what introduced outside
directors actually do for the improvement of firm performance. In section 2.2, we
presume that the board with outside directors, even if they are a minority, plays more
effective role in monitoring and advising management than all-insider boards. Therefore,
the introductions could improve firm performance by reinforcing the monitoring and
advisory role of the board. To provide the direct evidence for this prediction, we
examine whether the presence of outside directors actually affects monitoring and
advisory role of the board in this section.

5.1 The presence of outside directors and president turnover
To examine whether the presence of outside directors affects monitoring role of the
board, we analyze the effect of the board with outside directors on the likelihood of
president turnover compared to that of all-insider board. The sensitivity of top manager
turnover to firm performance may be considered a measure of the intensity of board
monitoring.
For this purpose, we estimate cross-sectional time-series logit models from 1996 to
27
2006 with clustered standard errors at firm level. The dependent variable is dummy
variable coded as one for firm-years with president forced turnovers and zero for
firm-years with no forced turnovers. Using Yakuin Shikiho [Directory of Directors], we
follow each president of our sample firms from 1996 to 2007 to identify those replace
during this period and find 652 president turnovers
26
. To distinguish between voluntary
turnover and forced turnover, we refer to turnover events where the president does not
remain on the board of directors as chairman or vice chairman and media (the Nikkei)
does not report the reason for the president change is normal retirement as forced
turnovers following Kaplan (1994) and Kang and Shivdasani (1995). This yields 125
forced turnovers.
Table 12 presents the results for the likelihood of president force turnover. In column
(1), the regression controls for firm performance, the age and tenure of the president and
inside directors ownership. We measure firm performance using industry-adjusted
OROA which is calculated as the difference from industry medians (calculated with all
listed firms in the industry). Consistent with the previous studies of president turnover
in Japan (Kaplan, 1994; Kang and Shivdasani, 1995), the coefficient on
industry-adjusted OROA is negative and significant at 1 percent level.
In column (2), we add a dummy variable which take one if the firm has outside
directors regardless of number of them, and the interaction term between firm
performance and the outside director dummy to estimate the effects of the presence of
outside directors on the likelihood of forced turnovers. Estimated coefficient of the
interaction term is significantly negative, indicating that the relation between forced
turnover and performance is significantly stronger for firms with outside directors than
for firms with all-insider board. This result is consistent with our prediction that the

26
Turnover events that we could identify as due to a presidents death are excluded.
28
board with outside directors plays more effective role in monitoring and disciplining
managers than all-insider boards. However, the coefficient of industry-adjusted OROA
is still negative and significant, indicating that president forced turnovers is sensitive to
firm performance, even when the board is composed solely of inside directors.
In addition, we examine whether only one outside director affect the likelihood of
forced turnovers. For this purpose, we add the dummy variable which takes one if the
firms have multiple outside directors on their board, and the interaction term between
firm performance and the multiple outside directors dummy to the independent
variables. Therefore, the coefficients of this interaction indicate the difference in the
effect between firms with single outside director and those with multiple outside
directors. The results are shown in Column (3). We find that the inclusion of only one
outside director could increase the boards ability to monitor and discipline managers.
The estimated coefficient of the interaction term between firm performance and
multiple outside directors dummy is not significant at conventional level. But, the
coefficient of the interaction term between firm performance and outside director
dummy is negative and significant at conventional level. Thus, Japanese presidents are
more likely to lose their job for poor performance at firms with outside directors
regardless of the number of them.
Previous research shows that main banks play a crucial role in periods of financial
distress (Hoshi, Kashyap and Scharfstein, 1990). Kang and Shivdasani (1995) show that
the sensitivity of president turnover to earning performance is higher for firms with ties
to a main bank than for firms without such ties. Thus, the effective monitoring we find
might be due to the presence of banker outside directors. In order to control the effects
of banker outside directors, we add the dummy variable which takes one if the firms
have banker outside directors on their board, and the interaction term between firm
29
performance and the banker dummy to the independent variables. Therefore, the
coefficients of this interaction term indicate the difference between the effect of banker
outside directors and that of non-banker outside directors. The result is shown in
Column (4) of Table 12. We could not find the evidence that our results are attributed to
the presence of banker outside directors. The estimated coefficient of the interaction
term between firm performance and outside director dummy is negative and significant
at conventional level. But, the coefficient of the interaction term between firm
performance and banker dummy is not significant at conventional level.
To summarize our results, the probability of president forced turnovers increases
significantly following the firms low industry-adjusted operating performance. This
relation is significantly stronger for firms with at least one outside director than for
firms with all-insider board. These results clearly support our prediction that even
minority outsider participation is somewhat effective in monitoring managers.
In addition, our results may be complementary to the finding of Weisbach (1988) that
CEO turnover is more sensitive to firm performance when a majority of directors are
outsiders than when a majority of directors are insiders. Following Weisbach (1988) and
our results, we may indicate that insider-majority boards do better monitoring than
all-insider boards, although they do less monitoring than outsider-majority boards.

5.2 The presence of outside directors and the precision of managerial forecasts
To examine whether the presence of outside directors affects advisory role of the
board, we study management earnings forecasts. In section 2.2, we argue that outside
directors could be more likely than inside directors to provide accurate and realistic
forecasts to managers. If this is the case, we predict that managers tend to make more
optimistic management forecast, when they receive the advice only from inside
30
directors. But, managers tend to make more realistic and accurate management forecasts,
when they can receive the advice from outside directors.
To test this prediction, we analyze the relation of the presence of outside directors to
the precision of management sales and earnings forecasts
27
. In Japan, the stock
exchange rule governs disclosure and financial reporting practice for public companies.
These rules strongly encourage managers to provide regular forecast of sales and
earnings. As a result, large majority of public companies comply with this request and
so forecast disclosures are actually mandated in Japan, though they are voluntary in the
U.S. and Europe
28
. Due to the mandatory disclosures, Japan may be an ideal place to
examine the precision of management forecasts, because we can avoid the endogeneity
problem that arises when forecast disclosure is voluntary.
To provide evidence on whether the presence of outside directors affects management
forecasts, Table 13 reports sales and earnings forecast errors. Sales forecast errors is
defined as initial annual forecast sales minus realized sales, deflated by lagged sales
29
.
Earnings forecast errors is defined as initial annual forecast earnings minus realized
earnings, deflated by lagged total assets. Thus, our forecast errors take a positive value,
when the management forecast is optimistic. The information on the management
forecasts was taken from Nikkei Financial Quest provided by Nikkei. The sample period
is from 1997 to 2006, because Nikkei Financial Quest has provided the management
forecasts date since 1997.
The results in Table 13 show that Japanese managers tend to provide optimistic

27
Ajinkya, Bhojraj and Sengupta (2005) and Karamonou and Vafeas (2005) analyze the
relationship between the board structure and the properties of management forecasts in
U.S.
28
Kato, Skinner and Kunimura (2009) study Japanese management forecasts in detail.
29
Public companies are expected to release point forecasts of annual earnings at each
annual earnings announcement date. Therefore, managers provide initial annual
forecasts for year t when year t-1 earnings are announced.
31
management forecasts. For all firms, the mean (median) sales forecast error is 0.87%
(0.97%) and earnings forecast error is 0.67% (0.17%). This result is consistent with that
of Kato, Skinner and Kunimura (2009) which use a comprehensive sample of Japanese
firms. Next, we divide the sample into the firms with outside directors and those
without. The last column shows the results of difference of means and medians test
between the firms with outside directors and those without. One of the most striking
features is that the management forecasts of the firms without outside directors are more
optimistic than those of firms with outside directors. The mean and median both
forecast errors of firms without outside directors are higher than those with outside
directors, and all differences are statistically significant at 1% level.
However, the management forecast errors are affected by many factors. For example,
the unexpected fluctuation of oil-price strongly affects the forecast errors of oil
suppliers and users, although international oil-price is likely to have been beyond the
control of a single Japanese manager. To isolate the effect of the presence of outside
directors, we extend our analysis to a multivariate setting. Table 14 reports the results of
multivariate OLS regressions. We use sales forecast errors and earnings forecast errors
as our dependent variables. The choice of independent variables employed is based on
previous research on management forecasts (for example, Baginski and Hassell, 1997).
Each regression includes industry-year dummies to control for industry-year specific
effects, such as oil-price effect. We find that the presence of outside director is, as
expected, negatively associated with sales and earnings forecast errors, with the
coefficient statistically significant at 5% level. This result confirms the univariate
differences in forecast errors shown in Table 13.
Following our previous analyses, we also examine the effects of the number of
outside directors and banker outside directors. In columns (2) and (5), we add multiple
32
outside directors dummy to the independent variables. The estimated coefficients of
multiple outside directors dummy are not significant at conventional level. But, the
coefficient of outside director dummy is still negative and statistically significant. This
result might suggest that only one outside directors advice help managers to make more
realistic and accurate forecasts.
To control the effect of banker outside directors, we add banker outside director
dummy to the independent variables. The results are shown in columns (3) and (6). The
estimated coefficient of multiple outside directors dummy is significantly positive for
sales forecast errors. The net effect of banker outside director is 0.011% (= 0.772 +
0.761), which indicates that banker directors advice is similar to the insiders, because
banker director, especially from main bank, has detailed inside information about the
firm and projects through the lending process.
Overall, the results of univariate tests and multivariate tests is consistent with our
predictions that managers tend to make more optimistic management forecast, when
they receive the advice only from inside directors. But, managers tend to make more
realistic and accurate management forecasts, when they can receive the advice from
outside directors. Thus, the presence of at least one outside director increases the ability
of the board to advice managers.

6. Conclusion
In this paper, we examine whether the presence of outside directors affects the
effectiveness of the board and firm performance by studying the board of Japanese
firms. Traditionally, many Japanese public corporations have not had outside directors
on their boards. However, due to the recent amendments of the Japanese Commercial
Law and the increased pressure from investors, many Japanese firms introduced a few
33
outside directors into their all-insider boards. These introductions in Japan allow us to
compare the effects of the boards with outside directors to those without, although
previous studies which have focused primarily on U.S. firms cannot, because most U.S.
companies have had outside director on their boards for many years.
Using a sample of Nikkei 500 firms, we empirically find that the introductions of
outside directors into all-insider boards significantly improve firm performance by
enhancing board effectiveness in monitoring and advising managers. For operating
performance, introduction firms experienced a statistically significant increase in
average OROA of about 0.8% relative to matched firms which have similar firm
characteristics, but do not introduce outside directors and have all-insider board. For
firm value, we find that firms that introduce outside directors have a statistically
significant stock price increase at the time of announcement of this decision. These
significant improvements after introduction of outside directors are robust to controlling
the effects of the number of introduced outside directors and banker outside directors.
To explore how introduced outside directors improve firm performance, we study the
effects of the presence of outside directors on board monitoring and advisory role. To
examine the monitoring role of the board with outside directors, we analyze the
relationship between firm performance and president turnover. We find that probability
of president forced turnovers increases significantly following the firms low
industry-adjusted operating performance. This relation is significantly stronger for firms
with outside directors than for those without. In addition, this relationship still remains,
even when the board includes only one outside director. These results suggest that even
minority outsider participation can significantly enhance the effectiveness of the board
in monitoring and disciplining managers. To examine advising role of the board with
outside directors, we analyze the precision of management forecasts. In Japan, managers
34
are required to prove annual forecasts at the beginning of the fiscal year. Thus, we can
investigate how presence of outside directors affects managers forecasts without the
endogeneity problem that arises when forecast disclosure is voluntary. We find that
managers annual sales and earnings forecasts are, on average, optimistic. But, they are
more optimistic when board is composed solely of inside directors than when board
includes at least one outside director. This result suggests that outsider participation can
help managers to formulate better strategy and projects through providing realistic and
accurate advices.
The role of outside directors in the board room has been a central issue in the
corporate governance literature for several decades. But most of the evidence we have
on this topic is drawn from setting where most public firms already have outside
directors on their boards, which makes it impossible to econometrically identify the
effects of the presence of outside directors, because there is no variation in the
explanatory variable. The Japanese setting allow us to compare the effects of board with
outside directors to those without, and so provides evidence on how the presence of
outside directors affects the board effectiveness and firm performance.









35
Appendix 1. Determinants of the introductions of outside directors
In Japan, public companies can choose to have or not have outside directors on the
board, because amended Japanese company law does not mandate outside directors. If
the decision of the introduction is not a random but is related to various firm
characteristics, a method that assumes introductions are exogenous may produce a
biased estimate of the effect of introductions. In order to overcome this bias and identify
the causal effects of introductions, we use propensity score matching method. In this
appendix, we explain how to calculate the propensity score for the introductions of
outside directors.
The propensity score in our analysis is the probability of introductions of outside
directors into all-insider boards. We use multivariate logit regression to estimate the
likelihood of a firm introducing outside directors. The dependent variable is
introduction dummy, which take one if the firm introduce outside directors to their
all-insider boards
30
. We have 144 introductions of outside directors. The dependent
variable is equal to zero for all firm-years prior to the introduction year, and firm-years
subsequent to the introduction year are dropped
31
. In other words, the sample is
composed of the 3,434 firm-years which have all-insider board. Following the previous
studies in U.S. (Boone, Field, Karpoff and Raheja, 2008; Coles, Daniel and Naveen,
2008; Linck, Netter and Yang, 2008; Lehn, Patro and Zhao, 2009) which analyze the
determinants of board structure, the independent variables are proxy variables for the
complexity, costs of acquiring information and private benefits of the control. We use

30
Appointments of directors are usually made at the shareholders annual general
meeting, which takes place a few months after the end of accounting year. Hence, there is
a lag of several months between the independent variables and appointments.
31
Dropout of the introduction firms may produce a biased estimate of the determinants
of introductions. Therefore, we use hazard model instead of logit model, and obtain
similar results. Kato and Honjo (2009) argue that results from the logistic and
proportional hazard specifications are quite similar.
36
firm size (total sales), the number of business segments number of affiliated firms per
sales and the ratio of foreign sales to total sales to proxy for a firms complexity and
advising benefits. To proxy for information costs, we use the standard deviation of stock
returns, R&D intensity and the market to book ratio. To proxy for private benefits, we
use free cash flow and median industry OROA. Additionally, we use industry-adjusted
OROA, leverage, firm age, keiretsu dummy, foreign ownership and the characteristics
of president and inside directors as independent variables.
To avoid bias in our standard errors due to within-firm correlation across time, we
adjust standard errors for firm level clustering. We also repeat our logit analysis using a
random-effects methodology and find that our main results are unchanged. To address
the difficulties associated with outliers in the data, we winsorize all variables at the 1st
and 99th percentile values. Column (1) in Table A1 reports the results of multivariate
logit model. Using this result, we estimate the propensity score for introductions of
outside directors.
In column (2), we use three proxy variables, COMPLEX, INFOCOST and
PRIBENEFIT
32
, which are created by principal components analysis. Principal
components analysis could increase the power of the multivariate analyses by
circumventing difficulties arising from multi-collinearity. When we calculate the
propensity score for introduction using this result, the results are similar.
We also examine the propensity score for increased appointment. We use multivariate
logit regression to estimate the likelihood of a firm increasing outside directors. The
dependent variable is increased appointment dummy, which take one if the firm which
has a board with at least one outside director increases the number of outside directors.
Therefore, this dummy variable does not include the introductions of outside directors.

32
Refer to Section 4.1 for more detailed explanation.
37
We have 100 increased appointments of outside directors. The sample is composed of
the 1,405 firm-years which have at least one outside directors on the board. In addition
to the independent variables used in the analysis of introductions, the number of outside
directors is used as independent variable. Columns (3) and (4) in Table 3 report the
results. We calculate the propensity score for increased appointment based on the result
in Column (3), but we have similar results when we use the result in Column (4).



















38
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44
Table 1. Variable definitions
This table shows the definitions of the variables used in the analyses. All variables except Risk, management
forecast errors and information on the companies directors and presidents are obtained from The Corporate
Financial Databank, compiled by the Development Bank of Japan. Risk is calculated using the Kabuka
CD-ROM (published by Toyo Keizai Shinposya). Management forecasts are obtained from Nikkei Financial
Quest. The information on the companies directors and presidents was taken from Yuka Shoken Hokokusyo
[Japanese 10k] and Yakuin Shikiho [Directory of Directors] published by Toyo Keizai Shinposya.

Variable Defnitions
Assets (billion yen) Total consolidated assets.
Sales (billion yen) Total consolidated sales.
Segment Number of business segments.
Affiliated firm Number of affiliated firms divided by sales (billion yen).
Foreign sales (%)
Ratio of foreing sales to total consolidated sales. If the ratio is below 10 % or the
firm does not disclose the foreign sales, this variable takes 10 %, because the
duty of disclosure of foreign sales is imposed on the firm whose ratio of foreign
sales to total sales is over 10 %.
Risk (%)
Standard deviation of residuals from market model in which the firm's daily stock
returns over fiscal year are regressed on the TOPIX daily returns.
R&D (%)
Ratio of research and development (R&D) expenditure to total consolidated
assets.
MTB
Market value of assets (book assets minus book equity plus market value of
equity) divided by total assets.
FCF (%)
Free cash flow scaled by total assets, following Lehn and Poulsen (1989). Free
cash flow is earning after interest and tax plus depreciation minus dividends minus
bonus for directors.
Industry OROA (%)
Median OROA of all firms containd in The Corporate Financial Databank in
each industry. The Corporate Financial Databank covers most of listed firms
in Japan.
Leverage (%) Ratio of the sum of short-term debt and long-term debt to total assets.
OROA (%) Ratio of operating income before tax and interests to total assets.
Industry-adjusted OROA (%) OROA minus industry median OROA.
Foreign ownership (%) Ratio of foreign investors' ownership to total shares.
Firm age Firm age from foundation
Inside director ownership (%) Ratio of inside directors' ownership to total shares.
Keiretsu Equals one if the firm belongs to one of the six president's councils.
President age President's age.
President tenure Number of years served as president of the firm.
Sales forecast errors (%) Initial annual forecast sales minus realized sales, deflated by lagged sales.
Earnings forecast errors (%)
Initial annual forecast earnings minus realized earnings, deflated by lagged total
assets.
45
Table 2. Summary statistics
This table shows the summary statistics. The sample consists of the firms that were in the Nikkei 500 from 1996 to 2006; are not subsidiary firms (with 15% or
more owned by another firm); and whose primary industry is not financial services. For those firms that meet these criteria, we include all years with data
available between 1996 and 2006, even if the firm is not in the Nikkei 500 list in a particular year. The definitions of the variables are explained at Table 1.




Mean
Standard
deviation
Median Mean
Standard
deviation
Median Mean
Standard
deviation
Median t-test
Wilcoxon rank-
sum test
Number of firms
Assets (billion yen) 831 1430 303 1220 1900 468 670 1140 256 12.45 11.83
Sales (billion yen) 758 1560 271 1060 1860 391 636 1410 232 8.53 10.33
Segment 2.75 1.49 3 3.02 1.42 3 2.64 1.51 2 8.23 9.94
Affiliated firms 0.21 0.16 0.18 0.21 0.16 0.17 0.21 0.16 0.18 1.00 1.77
Number of affiliated firms 95.84 141.90 49 119.93 161.53 60 85.98 131.80 42 7.66 10.53
Foreign sales (%) 24.55 19.64 13.33 25.27 20.43 12.72 24.26 19.30 13.63 1.63 0.32
Risk (%) 2.23 0.89 2.09 2.03 0.83 1.87 2.32 0.90 2.19 6.93 6.65
R&D (%) 1.82 2.18 0.98 1.89 2.47 0.87 1.79 2.05 1.05 1.43 3.33
MTB 1.32 0.60 1.13 1.33 0.56 1.17 1.32 0.61 1.12 0.97 5.01
FCF (%) 5.41 3.31 5.31 5.38 3.32 5.31 5.43 3.31 5.32 0.52 0.13
Industry OROA (%) 5.79 2.15 4.91 5.85 1.96 5.49 5.77 2.22 4.87 1.11 2.45
Leverage (%) 59.30 21.87 61.59 61.85 21.05 65.66 58.25 22.12 59.99 5.21 5.75
OROA (%) 6.38 4.46 5.42 6.08 4.43 5.12 6.50 4.46 5.44 3.00 2.94
Industry-adjusted OROA (%) 0.59 4.08 -0.10 0.25 4.00 -0.37 0.73 4.11 -0.01 3.76 4.62
Firm age 79.95 41.58 77 80.70 43.25 76 79.64 40.88 77 0.48 0.20
Foreign ownership (%) 14.45 10.69 12.05 16.31 11.74 14.04 13.68 10.14 11.48 7.83 6.53
Keiretsu 0.26 0.44 0 0.27 0.44 0 0.25 0.43 0 1.60 1.60
Inside director ownership (%) 3.03 7.66 0.19 1.84 5.74 0.13 3.52 8.27 0.22 6.95 12.75
President age 61.70 6.60 63 62.14 6.59 63 61.53 6.59 63 2.72 3.40
President tenure 7.03 8.08 4 5.69 6.45 4 7.58 8.60 4 7.86 7.12
4839 1405 3434
All firms Firms with outside directors Firms without outside directors
With outside directors vs
without outside directors
46
Table 3. Changes in operating return on assets
This table shows the average and median changes in operating performance for introductions of outside directors by Nikkei 500 companies during the
1996-2006 period. Industry- and performance-adjusted OROA is defined as OROA minus median OROA for a counter group matched by two-digit industry and
by prior OROA performance. *, **, and *** indicate significance at the 10, 5, and 1 percent levels, respectively.
Number of
observations
Mean Median Mean Median
Introduction of outside directors
[-1, 0] 144 -0.075 0.299 0.172 0.552 -0.027 0.126 0.068 0.540
[-1, +1] 142 0.316 0.977 0.310 1.890 * 0.446 1.744 * 0.451 1.974 **
[-1, +2] 116 1.079 3.003 *** 0.879 3.676 *** 0.790 2.629 *** 0.740 3.080 ***
[-1, +3] 93 1.350 3.052 *** 1.079 3.019 *** 0.803 2.305 ** 0.580 2.033 **
Increased appointment of outside directors
[-1, 0] 44 0.489 1.266 0.598 2.112 ** 0.179 0.526 0.140 0.817
[-1, +1] 42 0.211 0.388 0.035 0.494 0.010 0.025 -0.206 0.019
[-1, +2] 37 0.867 1.169 0.361 0.777 0.055 0.084 -0.165 0.385
[-1, +3] 30 1.203 1.409 0.082 0.895 0.163 0.204 -0.065 0.381
Industry- and performance-adjusted OROA
t -Statistic z -Statistic
OROA
t -Statistic z -Statistic
47
Table 4. Differences in operating performance change from propensity score matching: Introductions of outside directors
This table shows the average and median changes in operating performance for introductions of outside directors by Nikkei 500 companies during the
1996-2006 period. Industry- and performance-adjusted OROA is defined as OROA minus median OROA for a counter group matched by two-digit industry and
by prior OROA performance. Control sample for each introduction is selected from non-appointment firms based on the propensity scores which are the
predicted probabilities of introductions from the logit regression in columns (1) of Table A1. *, **, and *** indicate significance at the 10, 5, and 1 percent
levels, respectively. Panel B shows ex ante firm characteristics.

Number of
observations
Treatment
group
Control group: nearest
neighborhood within
the same year
Difference
(Treatment
- control)
Control group: nearest
neighborhood within the
same year and industry
Difference
(Treatment
- control)
A. Changes in industry- and perormance adjusted OROA
Average
[-1, 0] 144 -0.027 -0.100 0.073 0.259 -0.106 0.079 0.288
[-1, +1] 142 0.446 0.084 0.362 1.106 0.077 0.369 1.053
[-1, +2] 116 0.790 -0.113 0.903 2.100 ** -0.039 0.829 2.005 **
[-1, +3] 93 0.803 -0.057 0.860 1.706 * -0.148 0.951 1.898 *
Median
[-1, 0] 144 0.068 0.079 0.068 0.523 -0.181 0.074 0.497
[-1, +1] 142 0.451 0.030 0.423 1.021 -0.060 0.601 1.359
[-1, +2] 116 0.740 -0.114 1.025 2.234 ** -0.221 0.844 2.543 **
[-1, +3] 93 0.580 0.056 0.734 1.730 * 0.047 0.574 1.713 *
B. Ex ante firm characteristics
Propensity Score 144 0.102 0.102 0.000 0.375 0.093 0.009 3.212 ***
Sales (billion yen) 144 723 943 -220 0.976 927 -203 1.074
Segment 144 2.958 3.035 -0.764 0.345 3.028 -0.694 0.367
Affiliated firm 144 0.224 0.229 -0.005 0.214 0.218 0.006 0.322
Risk 144 2.212 2.324 -0.112 0.574 2.045 0.167 2.680 ***
R&D intensity 144 2.206 2.441 -0.234 0.801 1.986 0.221 1.157
Market to book ratio 144 1.443 1.468 -0.025 0.321 1.450 -0.007 0.105
FCF 144 5.083 5.041 0.042 0.115 5.230 -0.148 0.393
Firm age 144 80.333 85.000 -4.667 0.747 82.472 -2.139 0.408
Foreign share 144 19.185 19.536 -0.352 0.339 19.391 -0.206 0.212
t -Statistic
(z -Statistic)
t -Statistic
(z -Statistic)
48
Table 5. Differences in operating performance change from propensity score matching: Increasing the number of outside directors
This table shows the average and median changes in operating performance for increased appointments of outside directors by Nikkei 500 companies during the
1996-2006 period. Industry- and performance-adjusted OROA is defined as OROA minus median OROA for a counter group matched by two-digit industry and
by prior OROA performance. Control sample for each appointment is selected from non-appointment firms based on the propensity scores which are the
predicted probabilities of appointments from the logit regression in columns (3) of Table A1. The increased appointments which followed the introductions or
other increased appointments within previous three years are excluded. *, **, and *** indicate significance at the 10, 5, and 1 percent levels, respectively.

Number of
observations
Treatment
group
Control group: nearest
neighborhood within
the same year
Difference
(Treatment
- control)
Control group: nearest
neighborhood within the
same year and industry
Difference
(Treatment
- control)
A. Changes in industry- and perormance adjusted OROA
Average
[-1, 0] 44 0.179 0.246 -0.067 0.144 0.215 -0.036 0.086
[-1, +1] 42 0.010 -0.181 0.191 0.346 0.053 -0.044 0.079
[-1, +2] 37 0.055 0.236 -0.182 0.223 0.173 -0.119 0.121
[-1, +3] 30 0.163 0.126 0.038 0.041 0.043 0.120 0.105
Median
[-1, 0] 44 0.140 0.070 -0.219 0.478 -0.065 0.215 0.070
[-1, +1] 42 -0.206 0.020 -0.012 0.344 -0.250 -0.039 0.019
[-1, +2] 37 -0.165 -0.255 -0.150 0.008 0.120 -0.400 0.385
[-1, +3] 30 -0.065 -0.305 -0.267 0.010 -0.355 -0.468 0.442
B. Ex ante firm characteristics
Propensity Score 44 0.168 0.164 0.005 1.005 0.119 0.049 3.689 ***
Sales (billion yen) 44 2800 2250 547 0.659 1390 1410 2.418 **
Segment 44 3.114 3.273 -0.159 0.492 3.182 -0.682 0.223
Affiliated firm 44 0.157 0.225 -0.068 1.637 0.169 -0.013 0.602
Risk 44 1.951 1.974 -0.023 0.143 1.908 0.043 0.471
R&D intensity 44 3.049 2.461 0.588 1.083 2.087 0.961 2.541 **
Market to book ratio 44 1.391 1.514 -0.123 0.674 1.232 0.158 1.328
FCF 44 6.369 6.367 0.002 0.003 6.109 0.261 0.397
Firm age 44 76.659 70.614 6.045 0.822 81.273 -4.614 0.859
Foreign share 44 26.720 20.850 2.080 0.689 18.000 4.905 2.497 **
t -Statistic
(z -Statistic)
t -Statistic
(z -Statistic)
49
Table 6. OLS regressions of changes in OROA on introduction of outside directors and firm
characteristics
This table shows the results of OLS regressions for changes in OROA. The sample is composed of
the firms with all-insider board. Introduction dummy takes one when the firms introduce outside
directors to their boards. Using principal component analysis, COMPLEX is the factor extracted
from sales, segment, affiliated firm and foreign sales. INFOCOST is the factor extracted from risk,
R&D and market-to-book ratio. PRIBENEFIT is the factor extracted from free cash flow and
Industry median OROA. In parentheses are robust standard errors corrected for clustering at the firm
level. *, **, and *** indicate significance at the 10, 5, and 1 percent levels, respectively.








Sample =
Dependent variable =
Time span =
0.352 0.800 ** 0.841 **
(0.255) (0.376) (0.372)
-0.016 -0.057 0.023
(0.161) (0.185) (0.201)
-0.328 0.428 0.636
(0.419) (0.274) (0.453)
-0.232 -0.363 -0.122
(0.276) (0.524) (0.300)
0.259 -0.361 -0.767
(0.381) (0.059) (0.548)
-0.123 *** -0.132 ** -0.106
(0.047) (0.059) (0.068)
0.631 *** 0.318 ** 0.205
(0.109) (0.131) (0.155)
0.523 *** 0.380 *** 0.292 **
(0.106) (0.117) (0.130)
0.307 *** 0.260 ** 0.211
(0.081) (0.106) (0.128)
-0.389 *** -0.404 *** -0.434 ***
(0.032) (0.036) (0.034)
Intercept
Industry dummy
Year dummy
R
2
Sample size 3398 3127 2833
Change in industry-adjusted OROA
Yes Yes Yes
0.193 0.182 0.196
Yes
Yes Yes Yes
Yes Yes
Introduction dummy
Introduction dummy x COMPLEX
INFOCOST
Log (Foreign share)
Industry-adjusted OROA
t-1
Introduction dummy x INFOCOST
Introduction dummy x PRIBENEFIT
COMPLEX
Introduction dummy x Log (Foreign share)
PRIBENEFIT
Firms without outside directors
-1 to 1 -1 to2 -1 to 3
50
Table 7. Cumulative abnormal returns for announcement of introduction of outside directors
This table shows the cumulative abnormal returns for introduction and increased appointments of
outside directors by Nikkei 500 companies during the 1996-2006 period. The events which have
confounding events around the event period are excluded. Market model CARs are computed using
days -220 to -21 as the estimation period for market model parameters. Two-stage CARs are
computed by weighting the market model CARs by the reciprocal of (1 p), where p is estimated
probability appointment from the logit regression in columns (1) or (3) of Table A1. *, **, and ***
indicate significance at the 10, 5, and 1 percent levels, respectively.




















Mean
CAR (%)
Median
CAR (%)
Number of
positive : negative
Introductions of outside directors (117 events)
[-1, +1] 1.025 2.332 ** 0.940 68:49 2.460 **
[-2, +2] 1.249 2.690 *** 1.040 70:47 2.743 ***
Increased appointment of outside directors (84 events)
[-1, +1] 0.164 0.396 -0.095 41:43 0.163
[-2, +2] 0.446 0.906 0.395 47:37 0.966
Introductions of outside directors (117 events)
[-1, +1] 1.192 2.469 ** 1.018 68:49 2.539 **
[-2, +2] 1.494 2.964 *** 1.070 70:47 2.990 ***
Increased appointment of outside directors (84 events)
[-1, +1] 0.048 0.099 -0.114 41:43 0.036
[-2, +2] 0.321 0.557 0.486 47:37 0.763
t -Statistic
for mean
CA
z-Statistics for
generalized sign
Panel B: Two-stage CARs
Panel A: Market model CARs
51
Table 8. Changes in industry- and performance-adjusted OROA for introductions of single and
multiple outside directors
This table shows the average and median changes in operating performance for introduction of single
and multiple outside directors by Nikkei 500 companies during the 1996-2006 period. Industry- and
performance-adjusted OROA is defined as OROA minus median OROA for a counter group matched
by two-digit industry and by prior OROA performance. The last column shows that the results of
t-test and wilcoxon rank-sum test to compare the difference of averages and medians between
appointment of single outside director and multiple outside directors. *, **, and *** indicate
significance at the 10, 5, and 1 percent levels, respectively.





















Observations Observations
Average
[-1, 0] 85 0.229 59 -0.395 1.435
[-1, +1] 84 0.704 * 58 0.071 1.219
[-1, +2] 70 0.895 * 46 0.630 ** 0.431
[-1, +3] 57 0.992 ** 36 0.503 0.682
Median
[-1, 0] 85 0.172 59 -0.108 1.558
[-1, +1] 84 0.517 ** 58 0.288 1.116
[-1, +2] 70 0.587 ** 46 0.895 ** 0.339
[-1, +3] 57 0.580 * 36 0.570 0.706
Changes in industry-
and performance-
adjusted OROA
Changes in industry-
and performance-
adjusted OROA
Introductions of outside directors:
multiple outside director
Statistics for
difference
Introductions of outside directors:
single outside director
52
Table 9. Cumulative abnormal returns for announcement of introductions of single and
multiple outside directors
This table shows the cumulative abnormal returns for introduction of single and multiple outside
directors by Nikkei 500 companies during the 1996-2006 period. The events which have
confounding events around the event period are excluded. Market model CARs are computed using
days -220 to -21 as the estimation period for market model parameters. The last column shows the
results of t-test and wilcoxon rank-sum test to compare the difference of means and medians between
appointment of single outside director and multiple outside directors. *, **, and *** indicate
significance at the 10, 5, and 1 percent levels, respectively.





























Observations Observations
Average
[-1, +1] 69 1.160 ** 48 0.831 0.367
[-2, +2] 69 1.061 * 48 1.697 ** 0.675
Median
[-1, +1] 69 0.550 48 1.090 * 0.280
[-2, +2] 69 0.440 48 1.130 *** 1.421
Introductions of outside directors:
single outside director
Introductions of outside directors:
multiple outside director Statistics for
difference CAR CAR
53
Table 10. Changes in industry- and performance-adjusted OROA for introductions of
non-banker and banker outside directors
This table shows the average and median changes in operating performance for introduction of
non-banker and banker outside directors by Nikkei 500 companies during the 1996-2006 period.
Industry- and performance-adjusted OROA is defined as OROA minus median OROA for a counter
group matched by two-digit industry and by prior OROA performance. The last column shows that
the results of t-test and wilcoxon rank-sum test to compare the difference of averages and medians
between appointment of single outside director and multiple outside directors. *, **, and *** indicate
significance at the 10, 5, and 1 percent levels, respectively.





















Observations Observations
Average
[-1, 0] 120 -0.076 24 0.216 0.505
[-1, +1] 119 0.427 23 0.544 * 0.168
[-1, +2] 97 0.880 ** 19 0.329 0.677
[-1, +3] 78 0.911 ** 15 0.238 0.709
Median
[-1, 0] 120 0.013 24 0.118 0.440
[-1, +1] 119 0.491 23 0.122 0.158
[-1, +2] 97 0.897 *** 19 -0.003 0.921
[-1, +3] 78 0.754 ** 15 -0.082 0.815
Introductions of outside directors:
non-banker
Introductions of outside directors:
banker
Statistics for
difference
Changes in industry-
and performance-
adjusted OROA
Changes in industry-
and performance-
adjusted OROA
54
Table 11. Cumulative abnormal returns for announcement of introductions of non-banker and
banker outside directors
This table shows the cumulative abnormal returns for introduction of non-banker and banker outside
directors by Nikkei 500 companies during the 1996-2006 period. The events which have
confounding events around the event period are excluded. Market model CARs are computed using
days -220 to -21 as the estimation period for market model parameters. The last column shows the
results of t-test and wilcoxon rank-sum test to compare the difference of means and medians between
appointment of non-banker outside director and banker outside directors. *, **, and *** indicate
significance at the 10, 5, and 1 percent levels, respectively.





























Observations Observations
Average
[-1, +1] 96 1.440 *** 21 -0.871 2.046**
[-2, +2] 96 1.660 *** 21 -0.224 1.577
Median
[-1, +1] 96 0.980 *** 21 -0.170 1.307
[-2, +2] 96 0.925 *** 21 0.990 0.572
Introductions of outside directors:
non-banker
Introductions of outside directors:
banker Statistics for
difference CAR CAR
55
Table 12. Logit regressions of the probability of forced president turnover on the presence of
outside directors and operating performance
This table shows the results of logit regressions of the probability of forced president turnover. The
sample consists of the firms that were in the Nikkei 500 from 1996 to 2006; are not subsidiary firms
(with 15% or more owned by another firm); and whose primary industry is not financial services. For
those firms that meet these criteria, we include all years with data available between 1996 and 2006,
even if the firm is not in the Nikkei 500 list in a particular year. Outside director dummy takes one
when the firms have outside directors on their boards. Multiple outside directors dummy takes one
when the firms have over two outside directors on their boards. Banker outside directors dummy
takes one when the firm have banker outside directors on their boards. In parentheses are robust
standard errors corrected for clustering at the firm level. *, **, and *** indicate significance at the 10,
5, and 1 percent levels, respectively.

Sample =
Dependent variable =
Time span =
0.352 0.800 ** 0.841 **
(0.255) (0.376) (0.372)
-0.016 -0.057 0.023
(0.161) (0.185) (0.201)
-0.328 0.428 0.636
(0.419) (0.274) (0.453)
-0.232 -0.363 -0.122
(0.276) (0.524) (0.300)
0.259 -0.361 -0.767
(0.381) (0.059) (0.548)
-0.123 *** -0.132 ** -0.106
(0.047) (0.059) (0.068)
0.631 *** 0.318 ** 0.205
(0.109) (0.131) (0.155)
0.523 *** 0.380 *** 0.292 **
(0.106) (0.117) (0.130)
0.307 *** 0.260 ** 0.211
(0.081) (0.106) (0.128)
-0.389 *** -0.404 *** -0.434 ***
(0.032) (0.036) (0.034)
Intercept
Industry dummy
Year dummy
R
2
Sample size 3398 3127 2833
Change in industry-adjusted ROA
Yes Yes Yes
0.193 0.182 0.196
Yes
Yes Yes Yes
Yes Yes
Introduction dummy
Introduction dummy x COMPLEX
INFOCOST
Log (Foreign share)
Industry-adjusted OROA
t-1
Introduction dummy x INFOCOST
Introduction dummy x PRIBENEFIT
COMPLEX
Introduction dummy x Log (Foreign share)
PRIBENEFIT
Firms without outside directors
-1 to 1 -1 to2 -1 to 3
56
Table 13. Summary statistics for management forecast errors
This table shows the average and median management forecast errors for Nikkei 500 companies during the 1997-2006 period. The firms
which have confounding events after the initial forecasts are excluded. Sales forecast errors is defined as initial annual forecast sales
minus realized sales, deflated by lagged sales. Earnings forecast errors is defined as initial annual forecast earnings minus realized
earnings, deflated by lagged total assets. The last column shows that the results of t-test and wilcoxon rank-sum test to compare the
difference of averages and medians between appointment of single outside director and multiple outside directors. *, **, and ***
indicate significance at the 10, 5, and 1 percent levels, respectively.











All firms
Firms with
outside directors
Firms without
outside directors
Sales forecast errors (%)
Mean 0.872 0.128 1.180 4.129 ***
Median 0.986 0.474 1.329 4.322 ***
Earnings forecast errors (%)
Mean 0.668 0.452 0.757 3.697 ***
Median 0.166 0.050 0.214 4.697 ***
Statistics for difference
between firms with and
without outside directors
57
Table 14. OLS regressions of the management forecast errors on the presence of outside directors
This table shows the results of OLS regressions of the management forecast errors. The sample consists of
the firms that were in the Nikkei 500 from 1996 to2006; are not subsidiary firms (with 15% or more owned
by another firm); and whose primary industry is not financial services. For those firms that meet these
criteria, we include all years with data available between 1997 and 2006, even if the firm is not in the Nikkei
500 list in a particular year. The firms which have confounding events after the initial forecasts are excluded.
Sales forecast errors is defined as initial annual forecast sales minus realized sales, deflated by lagged sales.
Earnings forecast errors is defined as initial annual forecast earnings minus realized earnings, deflated by
lagged total assets. Outside director dummy takes one when the firms have outside directors on their boards.
Multiple outside directors dummy takes one when the firms have over two outside directors on their boards.
Banker outside directors dummy takes one when the firm have banker outside directors on their boards. In
parentheses are robust standard errors corrected for clustering at the firm level. *, **, and *** indicate
significance at the 10, 5, and 1 percent levels, respectively.

Dependent variable =
5.575 5.616 6.032 3.905 4.014 * 3.885
(7.374) (7.389) (7.352) (2.376) (2.394) (2.373)
-0.606 ** -0.626 * -0.772 ** -0.194 ** -0.246 ** -0.187 *
(0.293) (0.357) (0.335) (0.088) (0.109) (0.133)
0.042 0.114
(0.448) (0.145)
0.761 * -0.033
(0.457) (0.133)
-0.049 -0.049 -0.049 -0.058 ** -0.057 ** -0.058 **
(0.075) (0.075) (0.075) (0.025) (0.025) (0.025)
-0.186 -0.187 -0.187 -0.131 *** -0.133 *** -0.131 ***
(0.173) (0.173) (0.172) (0.043) (0.043) (0.043)
-0.326 * -0.328 * -0.344 * -0.102 ** -0.106 ** -0.102 **
(0.177) (0.177) (0.177) (0.049) (0.049) (0.049)
0.304 0.305 0.321 0.080 0.080 0.079
(0.297) (0.297) (0.299) (0.086) (0.086) (0.087)
-2.482 ** -2.482 ** -2.460 ** 0.173 0.173 0.171
(1.166) (1.166) (1.164) (0.366) (0.366) (0.366)
-0.035 *** -0.035 *** -0.035 *** -0.004 -0.004 -0.004
(0.011) (0.011) (0.011) (0.003) (0.003) (0.003)
0.374 0.373 0.387 0.236 *** 0.234 *** 0.235 ***
(0.239) (0.239) (0.240) (0.074) (0.074) (0.075)
0.085 0.084 0.080 0.047 0.046 0.047
(0.137) (0.136) (0.137) (0.043) (0.042) (0.043)
-0.990 ** -0.990 ** -0.974 ** -0.121 -0.120 -0.122
(0.492) (0.492) (0.491) (0.141) (0.141) (0.141)
-0.837 -0.832 -0.828 0.417 0.431 0.417
(0.940) (0.940) (0.936) (0.328) (0.330) (0.328)
-0.006 -0.005 -0.048 -0.365 *** -0.363 *** -0.364 ***
(0.409) (0.409) (0.411) (0.122) (0.122) (0.123)
-0.042 -0.042 -0.052 0.039 0.040 0.040
(0.193) (0.193) (0.191) (0.062) (0.061) (0.061)
1.458 1.453 1.470 0.223 0.209 0.222
(1.566) (1.568) (1.563) (0.538) (0.539) (0.538)
-0.314 ** -0.315 ** -0.318 ** -0.063 -0.063 -0.063
(0.160) (0.160) (0.159) (0.058) (0.059) (0.059)
Industry-year dummy
R
2
Sample size
Sales forecast errors Earnings forecasts errors
(1) (3) (4) (6) (2) (5)
Industry OROA
Intercept
Log (Sales)
Foreign sales
Multiple outside directors dummy
Banker outside director dummy
Log (Segment)
Affiliated firm
Outside director dummy
Industry-adjusted OROA
Yes Yes Yes
Leverage
Log (Firm age)
Risk
R&D
MTB
Log (President age)
Log (President tenure)
Yes
Log (Inside director ownership)
0.183
4235 4235 4227 4227
0.240
4235
0.183
4227
0.240 0.241 0.183
Yes Yes
58
Table A1. Propensity to introduce outside directors
This table shows the results of logit regressions of the probability of initial or increased appointments of
outside directors. The sample consists of the firms that were in the Nikkei 500 from 1996 to 2006; are not
subsidiary firms (with 15% or more owned by another firm); and whose primary industry is not financial
services. For those firms that meet these criteria, we include all years with data available between 1996 and
2006, even if the firm is not in the Nikkei 500 list in a particular year. The definitions of the variables are
explained at Table 1. Using principal component analysis, COMPLEX is the factor extracted from sales,
segment, affiliated firm and foreign sales. INFOCOST is the factor extracted from risk, R&D and
market-to-book ratio. PRIBENEFIT is the factor extracted from free cash flow and Industry median OROA.
In parentheses are robust standard errors corrected for clustering at the firm level. *, **, and *** indicate
significance at the 10, 5, and 1 percent levels, respectively.
59

Sample =
Dependent variable =
-2.248 1.780 -8.152 -0.596
(4.384) (3.789) (7.363) (5.198)
0.176 0.304 *
(0.126) (0.178)
0.365 ** 0.398
(0.181) (0.327)
1.449 ** -0.364
(0.695) (1.197)
-0.002 0.002
(0.008) (0.008)
0.161 * 0.313 ***
(0.086) (0.096)
0.375 ** 0.200
(0.171) (0.277)
0.144 ** 0.045
(0.061) (0.084)
0.329 * -0.051
(0.177) (0.304)
0.384 *** 0.070
(0.104) (0.161)
-0.154 *** 0.022
(0.041) (0.044)
-0.096 0.034
(0.087) (0.094)
-0.544 *** 0.103
(0.138) (0.143)
-0.301 ** -0.339 ***
(0.119) (0.119)
0.035 -0.010 -0.037 -0.054
(0.040) (0.033) (0.047) (0.041)
-0.004 -0.003 -0.012 -0.010
(0.007) (0.007) (0.011) (0.011)
-0.172 -0.218 -0.778 ** -0.523
(0.285) (0.292) (0.374) (0.376)
0.564 *** 0.530 *** 0.652 ** 0.039 ***
(0.159) (0.154) (0.322) (0.015)
-0.057 0.014 0.525 0.525
(0.248) (0.258) (0.391) (0.371)
-0.104 -0.120 0.167 0.179
(0.121) (0.121) (0.205) (0.210)
-0.791 -0.888 0.311 0.063
(1.017) (0.982) (1.384) (1.328)
0.087 0.055 -0.134 -0.153
(0.111) (0.109) (0.155) (0.161)
Industry dummy
Year dummy
Pseudo-R
2
Sample size
Log (Foreign share)
Log (Firm age)
Log (President age)
Keiretsu dummy
(1) (2) (3) (4)
Introduction
of outside directors
Increased appointment
of outside directors
Risk
Intercept
Log (Sales)
Yes
R&D
MTB
FCF
Industry OROA
Industry-adjusted OROA
Leverage
Log (Inside director ownership)
Log (President tenure)
Yes Yes Yes
INFOCOST
PRIBENEFIT
Number of outside directors
3434 3434 1405 1405
Yes Yes Yes Yes
0.139 0.130 0.165 0.162
COMPLEX
Log (Segment)
Affiliated firm
Foreign sales
Firms without outside directors Firms with outside directors
60
Figure 1. The ratio of the firms with outside directors
This figure shows the ratio of the firms having outside directors on their boards in our sample. The
sample consists of the firms that were in the Nikkei 500 from 1996 to 2006; are not subsidiary firms
(with 15% or more owned by another firm); and whose primary industry is not financial services. For
those firms that meet these criteria, we include all years with data available between 1996 and 2006,
even if the firm is not in the Nikkei 500 list in a particular year.
























0%
10%
20%
30%
40%
50%
60%
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
61
Figure 2. The ratio of the firms classified by the number of outside directors on their boards
This figure shows the ratio of the firms having outside directors on their boards in our sample. The
sample consists of the firms that were in the Nikkei 500 from 1996 to 2006; are not subsidiary firms
(with 15% or more owned by another firm); and whose primary industry is not financial services. For
those firms that meet these criteria, we include all years with data available between 1996 and 2006,
even if the firm is not in the Nikkei 500 list in a particular year.







0.0%
5.0%
10.0%
15.0%
20.0%
25.0%
1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
1
2
over3