Back to basics on corporate governance
For corporate governance experts in Japan there must have been a feeling of déjà vu when a report issued on 6 December confirmed that directors at Olympus Corp. had actively participated in a ruse dating back to the 1990s to hide $1.7 billion in investment losses.
The revelations at the global leader in endoscope production served to highlight the systematic failure of corporate governance in Japan seen previously at firms such as Seibu Railway Co., which was delisted in 2004 after falsifying ownership of Kokudo Corp., and other major shareholders for more than 40 years.
“The core part of management was rotten and the parts around it were also contaminated by the rot,” the report issued by an Olympus-commissioned independent panel said.
Scandals in the US involving companies such as Enron and WorldCom led to the Sarbanes-Oxley Act of 2002 reforms that have changed the ways US companies do business, but it may be premature to hope for such extensive changes in Japan, where the chief business association – Nippon Keidanren – opposes the introduction of tougher laws. Keidanren is taking the stance that Olympus is an isolated case and that legal changes are not the answer.
Following the US and European models, there has been increased interest in Japan about the role played by outside directors, who monitor and check the activities of internal directors. Under Japanese law, a director is an outside director if he is not, and has never been, a representative director, an executive officer, accounting adviser or employee of the company or any of its subsidiaries. Rules in the US are much tougher, also excluding representatives of firms with which the company has business relationships.
In December, a Ministry of Justice advisory panel proposed that listed companies have at least one outside director. This rule is similar to a requirement for an outright majority of independent directors in the case of companies listed on the New York Stock Exchange.
The Tokyo Stock Exchange requires companies to have either an outside director or an outside auditor. However, the ability of an outside auditor to challenge the CEO is limited by the auditor not having a vote on the board. Japanese boards continue to be composed predominantly of company insiders, who blur the line between the pursuit of profits and corporate oversight by operating both as company officers and directors.
There is opposition to changing this situation, and even the presence of outside directors is no guarantee that illicit practices will be prevented. Olympus maintained three outside directors, but “nobody found any incentive to speak,” says Takeyuki Ishida, head of Japan Research at Institutional Shareholder Services (ISS). “This reinforces my view that human beings remain incentive-based animals.”
Despite high levels of foreign ownership of Japanese stocks, ingrained Japanese business practices may be enough to prevent outsiders from having a bigger say on the board for now.
“Corporate governance in Japan clearly needs a shake-up,” says James Lawden, partner at Freshfields Bruckhaus Deringer. “An increase in requirements for genuinely independent directors could be an answer, but it may be counter-cultural to introduce such an outside force into a Japanese organisation.”
It comes as no surprise in the post-Sarbanes-Oxley world that US institutional investors have begun to raise questions with advisory companies regarding transparency at Japanese companies.
“Our clients are asking us why we are not being more severe with Japanese companies,” Ishida says.
In answer to this rising tide of voices, in 2013 ISS will alter its policy on Japanese companies, and in the case of companies with no outside directors it will oppose CEOs in Japan at shareholder meetings regarding motions to appoint directors. So far the Rockville, Maryland-based company has not opposed CEOs based on the absence of outside directors alone.
ISS will leave in place a policy to oppose CEOs in Japan at firms with controlling shareholders that do not have two independent directors. ISS defines an independent director as one having no relationship with a company aside from being appointed as an outside director.
While it is hard to find any saving grace in a corporate scandal that threatens to see Olympus delisted and partially sold off, it may be the relative absence of personal avarice among upper management that sets this case apart from scandals such as those involving Enron and WorldCom.
The 185-page independent panel report highlighted the “tribal culture of the Japanese salary man” at Olympus.
“We repeatedly see frauds in Japan designed not to enrich top management, but to preserve the firm as a going concern in order to protect the job security of management and other employees,” says Curtis J Milhaupt, Parker Professor of Comparative Corporate Law, Fuyo Professor of Japanese Law, Columbia Law School. “Cases like Olympus stem from Japan’s employment system, where there is essentially no lateral market for senior managerial talent. Managers want to protect the firm from failure at all costs, because they and their fellow employees have nowhere else to go.”
Nick Benes is among a growing group of business people who believe it is necessary to increase awareness of the need for corporate governance among directors in Japan. A long-term resident of Japan, Benes has a unique perspective on the recent scandals, based on his training as a lawyer and experience as an investment banker who served as an independent director at companies such as Livedoor after founding president Takafumi Horie departed amid accusations of securities fraud. Benes is not impressed by what he has seen in Japanese boardrooms.
“I was disturbed by the lack of basic knowledge about the law, governance, and legal liabilities and duties on the part of many directors,” Benes says. “There was even a lack of consensus between participants about the need for boards or what the goals of the board should be.”
That situation prompted Benes to establish, in 2009, the Board Director Training Institute of Japan (BDTI), an NPO now certified by the government as a rare “public interest organisation.” Its mission is to increase trust between corporations and the public, and contribute to the safe and ethical development of the Japanese economy and Japanese companies by improving corporate governance and accelerating the spread of effective management methods.
BDTI offers low-cost e-learning programmes covering Japanese company law along with corporate governance theory and practice, seminars and intensive “director training” programmes, together with specialists, such as Deloitte Touche Tohmatsu, major law and consulting firms, and leading professors.
“At BDTI, new directors learn how to be more effective as company representatives who are legally accountable to shareholders and society, and not to the company president,” Benes says. “What I hope for most is that they acquire the dedication to ‘do the right thing’ in this special role. There is no substitute for such integrity.”