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Tuesday, Dec. 13, 2011

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THE ZEIT GIST

Corporate governance in the shadow of Olympus


According to the "third-party committee" of outside experts appointed by Olympus to investigate the accounting scandal recently exposed by its sacked CEO, Michael Woodford, at least some of the company's directors, auditors and employees failed to stop or were even complicit in an ongoing effort to hide massive investment losses dating back to the early 1990s.

We lawyers like to confuse people with words rather than numbers, so I won't even pretend to understand how you conceal red ink by paying eye-popping fees to shadowy Cayman Islands advisers for overpriced acquisitions. One thing that is sure, however, is that the scandal will result in a lot of navel-gazing about corporate governance in Japan. Again.

Corporate governance — the rules on how companies should be managed — has long been an issue for foreign investors in Japanese firms. Shares supposedly represent fractional ownership interests in the company that issued them. Yet outsiders who become significant owners of Japanese companies often find themselves given the cold shoulder, not being allowed to appoint directors or otherwise have a say in corporate affairs commensurate with their ownership.

Most equity investors expect to benefit from their stake. Whether this is through share buybacks, higher dividends or a better stock price may depend upon the investor. Realizing an increase in value may necessitate changes in management policy — it may even require a change of management.

Most directors, however, want to keep their well-compensated posts. Furthermore, having often worked at their companies for decades, many Japanese board members would probably prefer to use profits for the sake of the employees who generated them rather than pay dividends to a bunch of outsider shareholders. After all, most shares in public companies are bought from strangers through a stock exchange transaction that brings no benefit to the company that issued them.

Any corporate governance scheme, therefore, has to manage the conflict of interests between the company's shareholders and those who supposedly manage the company on their behalf, its board of directors. Most Japanese firms (Olympus included) also have a German-modeled board of "statutory auditors" who supposedly provide an additional layer of oversight.

Many Japanese boardrooms are stacked to the gills with insiders — former employee directors and statutory auditors who may be more inclined to trust their subordinates and look the other way, or who have simply become corrupted by a warped "insider logic" that results in corporate decisions that are incomprehensible to outsiders. This tendency can sometimes manifest itself in a course of systematic lying to outside shareholders through falsified accounts or other deliberate misinformation.

Corporate scandals like Olympus are thus seized upon as yet another example of bad "Japanese-style" management systems. Corporate governance gurus propose solutions, most of which tend to revolve around ensuring that firms have at least some directors from outside the company and ideally an independent and number-savvy audit committee to oversee the books. These are not currently required by law, so perhaps the Ministry of Justice will revise the Company Act (again . . . ) to provide for more robust corporate governance structures and more stringent qualifications for directors.

Before I go any further I should probably disclose that my own view on the subject of Japanese corporate governance is heavily colored by the explanation a leading scholar of comparative law gave me to explain why he stopped doing research in the area: "Because it's all bulls—t." Since who is in the Cabinet this month does not seem to have much bearing on how Japan is actually governed, the amount of attention given to who sits on the country's corporate boards sometimes surprises me.

It seems plausible that at least some companies may be run the same way the country apparently is — not by those who are nominally (or, as some might prefer, "legally") in charge, but by the anonymous men in suits just below them who have spent decades of their lives working their way up through the ranks. When the time comes, the best of these will be promoted to director, the second-best to statutory auditor. A promotion to the board may entitle them to continue taking money from the company beyond the mandatory retirement age that applies to mere employees. This being the case, it may be more fruitful to try to understand at least some corporate boards more as an extension of a company's HR system rather than anything concerned primarily with shareholder value.

Of course, this dynamic is what some investors want addressed by corporate governance reform. Outsider board members, goes the thinking, are likely to be more rigorous in demanding explanations for corporate actions that don't make sense objectively. They may also be more likely to oppose efforts to run the company primarily for the benefit of insiders.

The trouble with a concept like "outside director" is that a lot of fruitless time can be spent trying to define what it means. Olympus had both outside directors and corporate auditors — even a risk management committee — yet it didn't prevent a continuing pattern of (alleged) accounting fraud.

The third-party report notes that the company's outside directors were effectively management cronies and recommends that the company appoint "true" outsiders, but offers no guidance as to what that means. In any case, there are plenty of examples of scandals at Western companies with exactly the type of outsider-heavy boards that are being demanded in Japan.

However "outsider" is defined, the deeper issue with Japanese corporate boards may be one of too much trust or interdependence. A board of insiders is likely to be a group of people that know and trust each other to act in a certain way, or to at least have the same basic interests which, in addition to protecting their pay packets, may include keeping fiscal unpleasantness from the past (when they may have been involved as employees) under wraps.

Adding outside directors who are just interdependent on a higher level — the "Japan, Inc." level, if you like — may not result in very much change. For decades major Japanese companies have had a network of cross-shareholdings in each others' firms to cement relationships, safeguard against hostile takeovers and help ensure that annual meetings are brief formalities. Why should boards with a few "outside" directors from other Japanese companies be expected to function differently?

In my mind, the only meaningful test of whether a board member is an "outsider" is if they can leave the company on bad terms and still eat lunch in town again. Under this standard, despite having worked for Olympus for 30 years, Woodford was more of an outsider than anyone else on the company's board, because he had to leave not just the company but the country as well. That he was in fact ordered to do so after being summarily sacked for disclosing the scandal illustrates that whistle-blower protection is as much a corporate governance issue as "outsider" status, however the latter is defined. Interestingly, although the third-party committee report contains a brief recommendation that the company establish an "external" whistle-blowing mechanism, it says nothing about actually protecting whistle-blowers, despite the glaring example of Woodford's shoddy treatment.

The panel summarily denies finding any evidence of the involvement of "antisocial forces" (mobsters) in the scandal, though this would help to explain Woodford's abrupt repatriation and subsequent security concerns, not to mention the reluctance of other directors to stand up and be counted. With law enforcement officials in Japan and other nations now looking into the scandal, the truth of the matter remains to be seen.

While ties with criminal organizations are a corporate governance concern everywhere, to me the real elephant in the room in Japan is not the yakuza but the government. By my count, two-thirds of the firms comprising the TSE's Topix Core 30 index of the country's largest listed companies have former bureaucrats on their boards. The presidency or similar post on the board of a certain Japanese bank is apparently a traditional postretirement perk reserved for the top bureaucrat at the Ministry of Finance.

These people are another form of "outsider," of course, yet one wonders if foreign investors (or even Japanese investors, for that matter) would like to see more of them. In any case, just as with organized crime, the involvement of former bureaucrats in more anonymous positions may be the real issue. For example, embattled Tepco is reported to have scores of former bureaucrats (including a couple dozen former police officials) on the payroll as "advisers."

It is very difficult to have a discussion about how companies like this should be managed using standard corporate governance terms and concepts. Whatever arguments you might make about improving performance and increasing shareholder returns by replacing management or cutting costs are probably meaningless if in doing so you annoy the people who regulate you by eliminating a source of postretirement jobs.

Not all companies are like this, of course, but it is rare to see corporate governance discussed in a manner that distinguishes between "normal" firms and those that may play a role in providing lifetime employment for top bureaucrats. Perhaps it is not discussed because it is so obvious to anyone in the know, or because nothing good will come to anyone who mentions it openly. In this respect, everyone in corporate Japan may be an "insider" of sorts.

This issue aside, most debate on corporate governance seems to focus on the design of formalistic structures (audit committees and so forth) and qualifications (how outsider status is defined). If we analogize a corporation to a car, however, no matter what safety requirements you impose on automobile design and the qualifications for a driver's license, some companies will persistently putter along at the speed limit in the passing lane while others get driven off a cliff, full of screaming passengers.

The ultimate issue for corporate governance in Japan, therefore, should be rewarding safe yet efficient driving. This involves punishment for bad drivers and remedies for their victims. While the government can and does impose criminal sanctions on fraudulent corporate activity, official resources are limited and enforcement can seem sporadic. The much greater source of incentives would seem to be the ability of shareholders to sue board members for unlawful behavior. In fact, I recently attended a seminar where a veteran Japanese corporate lawyer opined that the only legal change during in his 30 years of practice that had any real positive impact on corporate governance was the lowering of filing fees for shareholder lawsuits.

Yet Japanese law has never been big on judicial remedies. Even when courts do find directors liable, they may be decisions by judges too busy to even manage their own household finances, second-guessing corporate decisions with the benefit of hindsight, usually after a major failure. Thus, if courts have any influence on corporate behavior at all, it may be to either discourage doing anything new and unproven, or to encourage hiding failures, even when they are the result of business judgments that were reasonable at the time they were made.

Furthermore, the issue of remedies relates to larger issues about Japan's system of so-called stakeholder capitalism. Under Japanese corporate law, shareholders are generally the only parties entitled to pursue legal redress for bad management. At the same time, however, it is widely accepted that Japanese companies are actually run for the benefit of a broader range of stakeholders beyond their owners — employees in particular, but also vendors, customers, lenders and so forth. What's more, these other stakeholders may actually be harmed by steps which could benefit shareholders — a buyout or change in management which leads to cost-cutting lay-offs, for example.

Yet, nonshareholder stakeholders do not themselves have any formal legal remedies against a company for bad or oppressive management. The pursuit of their interests is left by default to courts and other government agencies, which may protect them by making firing employees more difficult than the law actually mandates, or by avoiding confrontations between different stakeholders by rendering aggressive corporate transactions next to impossible in the first place.

Thus, the distinction between corporate governance in Japan and plain old governance may not be as big as some people think.

Colin P. A. Jones is a professor at Doshisha Law School in Kyoto. Send comments and story ideas to community@japantimes.co.jp


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