It may have taken a foreign whistleblower named Michael Woodford to force the issue. But with demands for change growing louder in the wake of the Olympus and other scandals, is Japan Inc. finally ready to accept reform?
Activists have been given plenty of ammunition in recent months, with Woodford exposing Olympus’s $1.7 billion accounting fraud following his ousting as chief executive, a scandal at Daio Paper over $140 million in illicit borrowings and a $2 billion pension fund fraud at AIJ Investment Advisors.
Similarly, a culture of collusion between companies and regulators in the so-called “nuclear village” has sparked heated debate over energy policy and shown the need for greater transparency.Enjoying this article? Click here to subscribe for full access. Just $5 a month.
According to analysts, a growing fiscal deficit has made the case for reform more pressing, given the risk to government and corporate pensions from an undervalued stock market. Adding to the clamor for change has been pressure from foreign shareholders, more willing than their domestic counterparts to publicly flex their muscles.
Yet judging by those surveyed by The Diplomat, reforms planned next year by the ruling Democratic Party of Japan (DPJ) barely scratch the surface of what needs to be done, with fierce resistance to change by the nation’s major business lobby groups and a mixed response from the Tokyo Stock Exchange (TSE). Notable among the reforms is the requirement that large companies appoint at least one outside director, along with other new rules aimed at strengthening shareholders’ rights.
Although most observers see improvement since the introduction of the new Company Law in 2006, Japan’s standards of corporate governance are still seen as lagging behind those of its Asian rivals.
“Foreign investors may not invest in Japan due to its opaque system of corporate governance,” warned Japanese corporate lawyer, Takao Shojima.
“The Tokyo Stock Exchange used to be one of the three major global centers, but now Hong Kong and Singapore are rising and one of the differences is corporate governance.”
The decline of cross-shareholdings among listed Japanese companies and the corresponding increase in foreign ownership has been cited as a force for change. According to brokerage Nomura Holdings, cross-shareholdings fell to a record low at the end of March 2011 of 11.1 percent of total outstanding shares – the lowest figure since the survey started in 1991.
Similarly, the proportion of Japanese shares held by foreign investors was at 26.7 percent, outweighing the 20.3 percent held by Japan’s 1.12 million individual shareholders, according to the TSE.
Yet for former Olympus boss Woodford, the decline in Japanese cross-shareholdings cannot happen too quickly.
In an interview conducted in early March 2012, he described the system as “an incestuous, cosy club of institutional shareholders.”
“The worst thing for Japan is the cross-shareholdings, because the unwritten rule is you don’t criticize and you don’t sell,” he said.
“It’s also harmful for Japan because it means you have mediocre boards staying there until people die or retire. There’s no hostile takeover within Japan so there’s no creative destruction.”
A 30-year veteran of the Japanese camera and endoscope maker, the Englishman became the first non-Japanese to be appointed Olympus CEO after a successful career with the company in Europe.
Yet Woodford was axed after demanding the resignation of then chairman Tsuyoshi Kikukawa and another executive over payments made for overseas acquisitions which “destroyed over U.S. $1.5 billion in shareholder value.”
Described by the Wall Street Journal as “one of the biggest and longest-running loss-hiding arrangements in Japanese corporate history,” the scandal over the tobashi (loss-hiding) cover-up saw billions of dollars wiped from Olympus’ market value and led to the arrest of Kikukawa and other executives, along with the removal of the entire company board.
Woodford abandoned a campaign to win back a board seat after failing to gain the backing of Japanese institutional investors, despite strong support from foreign shareholders including Southeastern Asset Management. In May, he settled an unfair dismissal claim against the company filed in Britain, reportedly for around 10 million pounds.
His experience sparked debate over the role of foreign executives in driving change at Japanese companies, of which Nissan Motors’ Brazilian-born CEO, Carlos Ghosn is the most prominent example.
“Do you think there’s going to be a large number of foreign executives queuing up to go to [Japan] after what happened to me? I don’t think many will be asked, because a lot of Japanese companies will say that’s what happens when you get a foreigner in,” Woodford said.
‘Everybody’s in cahoots’
Adding to the scandal at Daio Paper, where the company fired its chairman over borrowings reportedly used to pay private gambling debts, the Woodford saga heightened concerns over inadequate corporate governance and a general lack of disclosure from Japan’s entrenched corporate insiders.
However, the jury remains out as to whether Olympus showed a systemic failure of the system, with companies under pressure to increase diversity and “globalize” amid a shrinking domestic market and intensifying international competition.
“It’s not true to say that all Japanese companies have a corporate governance problem. But the views of foreign investors about it are understandable and there’s need for reform,” lawyer Shojima said.
Long-term Japan resident and company director George Olcott agreed, saying that most Japanese businesspeople were appalled by the Olympus scandal.
“I feel it’s a one-off. When I talk to Japanese business leaders they shake their heads and say, ‘What on earth did they think they were doing?’ Not just in how the company was run, but in sacking Woodford summarily when it was obvious there was something very bad going on,” said Olcott, also of the Judge Business School, University of Cambridge.
“Most Japanese people would see that as extremely egregious behavior, although I don’t think it’s a sign of any systemic issues relating to the governance of Japanese companies.”
An independent director of two Japanese companies, manufacturer Nippon Sheet Glass and insurer NKSJ, Olcott said Japanese companies were becoming more responsive to the views of their shareholders, but it was often the foreigners who spoke the loudest.
“One of the tragic things to me is that ‘shareholders’ in the minds of Japanese executives means foreign shareholders. The situation at Olympus was characterized in the Japanese newspapers as what would the foreign shareholders think of this situation – but it should be about all shareholders, and not just the foreigners,” he said.
“The general passivity of Japanese institutions is really quite sad, and I hope they will become more interested in the companies in which they are shareholders. It shouldn’t be left to the foreigners to make a noise [about governance].”
Yet corporate governance expert, Prof. Christina Ahmadjian of Hitotsubashi University said the Olympus case reflected a common pathology among Japanese companies.
“You have these executives who were appointed by the people before them. They do everything to cover up the mistakes of their seniors, everybody is in cahoots and they have this sense that we’re protecting the company and the people who came before us,” she said.
“There’s no sense of responsibility towards shareholders or anybody else, and that situation is fairly common.”
Ahmadjian has served as a director of the Japan Corporate Governance Research Institute (JCGR), which has conducted annual surveys on the corporate governance practices of companies listed on the First Section of the TSE with the aim of boosting standards.
In the 2011 survey, Sony, Toshiba and TDK took the top three rankings, with companies with better governance “tending to have more foreign ownership.”
“Companies that have good governance, at least according to our standards, tend to have truly independent directors, are good at communicating with shareholders and other stakeholders and have a clear separation between execution and monitoring. They also have a strong commitment by the CEO and the whole company to good governance,” she said.
While the link between governance and performance has long been debated, a recent study by Nomura Securities has shown a benefit for investors.
According to an April 9 report by the Nikkei, a study by the brokerage’s Kengo Nishiyama found that companies where foreign investors held at least 30 percent of shares had an above-average return on equity (ROE) of 8.5 percent, with the ROE figure for those at least 40 percent owned by institutional investors averaging 8.8 percent.
Nomura also found companies with average ROE exceeding 10 percent and with outside directors posted above-average gains in their market value.
“Since the scandals at Daio Paper and Olympus, retail investors have started steering clear of owner-run companies and firms with long-serving top executives,” the financial daily quoted kabu.com Securities’ Tatsunori Kawai as saying.
Reform drive stalls
The reform impetus provided by the Olympus scandal has rapidly evaporated, however, with DPJ moves to strengthen corporate governance facing strong opposition from business groups. While revisions to Company Act are expected to reach the Diet in 2013, major changes appear unlikely given the bigger political issues facing the embattled ruling party.
Among other reforms, the DPJ has pushed for the mandatory appointment of external directors by public companies. A Justice Ministry panel also recommended external directors, although without specifying whether they should be compulsory.
Other proposals have included strengthening audit oversight and allowing for multiple shareholder derivative lawsuits against subsidiaries as well as parent companies, along with measures on private placements.
While outside directors currently sit in the boardrooms of nearly half of all TSE-listed companies, they are in the majority at only 40 firms, including Hitachi, Hoya, Sony and now also Olympus.
The TSE has also urged companies to disclose information on the independence of their outside directors, amid criticism of the appointment of directors from group firms, “main banks” or other partner companies. Current TSE regulations require only the appointment of at least one independent director or auditor.
Yet according to the Nikkei, the Japan Business Federation (Keidanren), Japan Association of Corporate Executives (JACE) and the Japan Chamber of Commerce and Industry have all lobbied against the reform proposals.
“The Japanese economy will lose its international competitiveness if strict regulation is implemented as a result of generalizations based on a few bad apples,” a JACE official was quoted saying.
Another criticism is that mandatory outside directors will erode management autonomy and discourage “lifetime” employees from aiming for seats on the board.
“Outside directors are common in the United States, but in Japan there aren’t so many and companies argue it’s difficult to secure talented candidates,” lawyer Shojima said.
“Employees may also think that even if they work hard for their company, it will be impossible to become a director due to the hiring of outsiders.”
Yet the outside directors on Olympus’ former board failed to aid Woodford, who said companies “need a majority of outside directors and they need to be truly independent.”
Olcott described the effect of having a single outside director as “almost totally useless.”
“It’s very difficult to be the lone non-executive on the board. When you’re surrounded by executives, your ability to question and your willingness to do so is far less compared to a board which is more balanced,” he said.
He said despite the push towards globalization, the number of foreign directors at Japanese companies had barely increased over the past decade. In 2011, there were only 247 out of an estimated 41,000 directors – “a pathetically small number compared to Western countries.”
In appointing its first non-Japanese directors recently, Hitachi chairman Takashi Kawamura told the Nikkei that “boards of directors embracing members with different backgrounds are more likely to discern problems rather than boards controlled by closely knit members.”
JCGR’s Ahmadjian said companies committed to good governance had an incentive to appoint outside directors, along with increasing the available talent pool.
“When Japanese companies say there’s not enough people out there to be independent directors, I don’t believe that’s an excuse because there’s a lot of retired executives around, but just not that many women. It’s really hard for women to combine families and career here still, and not enough is being done about it,” she said.
Nicholas Benes, representative director of the nonprofit Board Director Training Institute of Japan (BDTI), has been an advocate for independent directors along with improved standards.
“The step that would have the biggest impact would be if the TSE required disclosure of corporate policies on director training. Some 85 percent of Japanese boards are made up of internal directors, and these directors often need training the most,” he said.
“You can put all the legal structures in place, but they’re only going to be marginally effective if the internal directors who dominate boards don’t understand their duties and obligations concerning such areas as internal controls, risk management or succession planning.
“Fundamentally, many directors here just don’t know much about the Company Law – all they know is that their boss, the president is sitting at the end of the table, and to them being a director is just a nice promotion.”
Benes said more independent directors were needed partly to improve transparency, and also to enhance the prospects of takeover bids.
“One of the reasons why you need more independence on Japanese company boards and committees is that these are the only people who can judge takeover bids neutrally. Until this happens no hostile takeover will be successful because there won’t be a group of people who are not self-interested to avoid them,” he said.
“It’s likely that the entire Japanese market is undervalued by at least 30 percent due to the lack of a takeover premium.”
Change or decline
While another Olympus-style scandal is difficult to predict, the reformers are hopeful of faster changes to reassure foreign investors and boost investment.
Nevertheless, few are willing to see Japan’s system completely replaced, given current advantages such as employee loyalty, lower executive compensation than in the West and greater incentives for long-term research and development.
Temple University’s Professor Jeff Kingston said the current burst of overseas investment could help drive reform.
“Japanese companies have been on an overseas buying spree over the past year because of the yen’s appreciation and the dim business prospects in Japan. This process of sharply increasing overseas acquisitions potentially could be a force for change, as companies are going to have to adapt to different standards and ways of doing business,” he said.
Analyst Naomi Fink of Jefferies (Japan) said foreign investors were encouraged by recent reforms, although they need not expect overnight change.
“Are foreign investors going to suddenly get an Anglo-Saxon model of corporate governance in Japan overnight? No. But are there visible improvements? Yes,” she said, pointing to moves against sokaiya corporate racketeers and tobashi transactions as examples, along with revised company laws.
“There are a lot of undervalued companies, overseas demand is increasing with U.S. economic data improving and Japanese companies have recovered from the shock of the Tohoku disaster. There are opportunities to be had and foreign investors are coming back,” she said.
Japan’s institutional investors have also started following their foreign counterparts in exerting more scrutiny on board candidates, with major asset managers reportedly planning to vote only for “truly” independent directors.
Ahmadjian said the pace of change would depend on the attitude of Keidanren, the nation’s most powerful business group.
“Keidanren has been responsible for slowing or stopping most corporate governance reform. If they finally realize that their position doesn’t make sense and start promoting reform, it would completely change the situation in Japan,” she said.