It has been two tough years for Japanese corporate governance. In 2010 Toyota's slow response to car recall issues raised questions about the governance of Japan's most highly respected company. The Tohoku Earthquake of March 11, 2011 cast a harsh light on preparedness and decision-making at Tokyo Electric Power Company, formerly Japan's financially strongest company, which subsequently found itself in financial ruin.
A recent, still unfolding, scandal over financial reporting at Olympus Corporation may be the worst of all. Like the Enron case in the US, it raises fundamental concerns about the accuracy of financial reporting and the role of outside audit firms in Japan. It has prompted global institutional investors to vigorously renew their criticism concerning a lack of transparency and accountability in Japanese corporate governance.
Problems at Olympus, a maker of cameras and medical devices, came to light in connection with a $2 billion acquisition of a British company, Gyrus Group Plc. Michael Woodford, a long-time British employee and the new company president, began to raise questions about extraordinarily high advisers' fees of $687 million paid by the company to obscure Cayman entities as part of that transaction. He was promptly fired and then went public with his concerns. There was much speculation in Japan as to why Olympus would pay exorbitant fees that did not pass "the smell test," including the possibility of an organized crime connection. It turns out that the reality was more prosaic, but even more troubling, due to the possibility that this may not be an isolated case.
What apparently occurred at Olympus was an extreme case of failure to recognize securities losses, or old-fashioned "tobashi" (literally "flying") that occurred with disturbing regularity in Japan in the 1990s. When the Japanese bubble burst around 1990, the Tokyo stock market lost some three-fourths of its value and many Japanese companies were stuck with very large securities losses (since, unlike US companies, many of them hold substantial portfolios of publicly-traded stocks on their balance sheets). Tobashi simply means that such bad assets are shuffled, sometimes repeatedly, or "fly" to another company's balance sheet, either to a friendly securities company or to the company's own subsidiary, so that the problem securities never appear on the company's balance sheet at the end of any accounting period.
In the case of Olympus, it appears that before the change to mark-to-market accounting standards in Japan in 2000, the company transferred its bad securities to a Cayman subsidiary. It later sought to deal with the unrecognized losses in this subsidiary, thought to total over a billion dollars, by using vastly inflated mergers and acquisitions advisory fees. These fictitious fees were presumably included in the acquisition price, which can be written down gradually over a 20-year period. It is truly amazing that such huge losses could be concealed and continue as a heavy financial burden on the company for (presumably) over 20 years. It also means that Olympus's securities filings may well have contained false financial statements for a 20-year period, which must be a new world record.
This case is reminiscent of Enron in that it seems clear that, going forward, the accuracy of financial statements and the role of outside auditors and the board of directors will be closely scrutinized. As in Enron, we can expect to hear the cries of "Where were the gatekeepers?" and "Where was the board?"
It appears that one outside auditor did object at one point to the treatment of these securities losses in the financial statements of Olympus and was replaced by another outside auditor. Two of the major Japanese audit firms (both affiliates of the Big Four accounting firms) are now under government investigation.
As in the Sarbanes-Oxley Act of 2002 that followed the Enron case, we can anticipate that additional regulation of audit firms may receive increased attention. The example of the Public Company Accounting Oversight Board (PCAOB) in the US is one possible model. Although it is an extreme example, the Olympus case serves as a reminder that all countries continue to wrestle with a system under which the company itself can choose (and dismiss) its most important gatekeeper the outside auditor.
The Olympus case is also important for the ongoing debate in Japan concerning independent directors. Japan has been slowest in incorporating the concept of independent directors, even compared to other countries in Asia such as South Korea and China. Olympus actually did relatively well on this count, having three outside directors among a total of 15. As in the Enron case, outside directors were not effective in preventing serious accounting fraud by corporate management. It is highly unlikely that the Japanese will respond with a Sarbanes-Oxley approach that requires a majority of independent directors for public corporations. Japanese companies are attached to the notion of directors who are thoroughly familiar with the company's business and remain skeptical of the value of outside directors to the corporation.
Given the results in Olympus, perhaps institutional investors and others concerned with good corporate governance practices should broaden their focus beyond the number of independent directors and their "degree" of independence. Maybe there should be greater consideration given to providing outside directors with the tools they need to act independently and fulfill their role of monitoring management. Chief among these tools is assuring a good information flow, both internally in terms of establishing and maintaining adequate information and reporting systems, and externally in terms of required public information disclosure. Both would tend to increase the effectiveness and value of outside directors and help overcome traditional corporate cultures in Japan that zealously guard corporate information and remain excessively inward-looking.
Following the Olympus scandal, foreign investors have escalated their criticism of Japanese corporate governance practices that they have long thought to be inadequate. It is too early to tell what, if any, new reforms will be initiated. However, ensuring the accuracy of financial statements is a fundamental issue of corporate governance, and there should be a meaningful Japanese response. Information flow is another basic issue that may, in fact, broadly link the recent corporate governance failures at Toyota, Tokyo Electric and Olympus. As such, it cries out for immediate attention.
Bruce Aronson is a Professor of Law at Creighton University School of Law. Prior to joining Creighton, he spent two years each as a Senior Fulbright Researcher at the University of Tokyo and as an Associate Research Scholar at Columbia Law School. Before that, he was a corporate partner at the New York City law firm of Hughes Hubbard & Reed LLP, where he was co-chair of the Financial Services Group. Aronson's current research focuses on comparative corporate governance.
Suggested citation: Bruce Aronson, The Need to Reform Japanese Corporate Governance, JURIST - Forum, Nov. 15, 2011, http://jurist.org/forum/2011/11/bruce-aronson-corporate-governanace.php.
This article was prepared for publication by Jonathan Cohen, the head of JURIST's academic commentary service. Please direct any questions or comments to him at firstname.lastname@example.org