This article was first published in the April 2012 International edition of Accounting and Business magazine.
Across the board, revelations that Olympus Corporation had hidden losses from bad investments came as a surprise. However, the biggest surprise was not that one of the most famous and well-respected Japanese electronics companies had concealed its actions from auditors, shareholders and regulators, but that financial jiggery-pokery had been going on for at least 13 years and that it involved US$1.7bn.
That Olympus got away with such a huge fraud for so long has raised new red flags over corporate governance in Japan, with prime minister Yoshihiko Noda weighing in on the debate, telling the Financial Times in an interview in late October that he feared the outcry over the scandal could lead to the assumption that such problems are rife throughout Japanese companies.
‘What worries me is that it will be a problem if people take the events at this one Japanese company and generalise from that to say Japan is a country that [does not follow] the rules of capitalism,’ he said. ‘Japanese society is not that kind of society.’
The problems at Olympus were first detailed in a story in the investigative journal Facta, issued on 20 July last year. The five-page story claimed that the company had used over-priced acquisitions and exorbitant consultancy fees to recover losses that it had made in investments in the years of Japan’s ‘bubble economy’ of the 1980s, but then went bad.
The convoluted scheme included a number of questionable payments, for the acquisition of three Japanese companies that were essentially worthless, and then US$687m to a little-known financial advisory company in the Cayman Islands when it purchased Gyrus ACMI, a British manufacturer of medical instruments, for US$2bn in 2008. Possibly because of the scale of alleged fraud, rumours have suggested the behind-the-scenes involvement of ‘anti-social forces’, a polite way of saying underworld gangs (yakuza), although this is something which the company denied at a meeting with its creditors in November.
Michael Woodford, the English chief executive who had worked for the company for 30 years and had only been made president on 1 April 2011, said he was ‘incredulous’ when he read the story, but that sense of disbelief deepened when he went into his office on the Monday and no one mentioned it.
Summoning a board meeting for the following day, he sensed an immediate change around the table when he got the magazine out and asked what was going on. The response from former president Tsuyoshi Kikukawa was that Woodford had not been told about the matter because he was ‘so busy’.
Over the coming days, the board attempted to persuade Woodford to drop the matter. He responded by commissioning an external report by PwC into the fees paid to the company’s advisers that revealed ‘a shameful catalogue of errors’, he said. Presenting it to the board, he requested the resignation of Kikukawa and Hisashi Mori, the executive vice president.
At the board meeting on 14 October, convened ostensibly to discuss ‘concerns over governance’, Kikukawa announced that the agenda had been altered and the only thing to discuss was the termination of Woodford’s contract.
Woodford was not allowed to address the board, was ordered to hand over his mobile phones and computers and told to vacate his apartment over the weekend. To add insult to injury, he was told he could not use a company car to get to the airport so he would have to take the bus.
Out in the open
Instead of going quietly, however, Woodford went public. The story appeared on the front page of the Financial Times on 15 October and, for the board of Olympus, the genie had escaped from the bottle.
Kikukawa resigned 11 days later but the new president, Shuichi Takayama, attempted to defend the board’s actions by blaming Woodford for leaking secret information that damaged the company’s share price. Nevertheless, the company admitted on 8 November that its accounting practices had been ‘inappropriate’ and that funds had been used to cover its investment losses.
Investigations have been launched by the UK’s Serious Fraud Office, The FBI in the US and in Japan, both the Financial Services Agency and the Tokyo Metropolitan Police.
Olympus’s stock market valuation, valued at 673 billion yen on 13 October, had fallen to 422 billion yen by the close of trading three days later and shareholders in Japan and overseas are reportedly initiating investigations that will lead to legal action against the company.
For its part, Olympus set up an initial investigation panel, made up of five independent lawyers and a Japanese certified public accountant. It issued The Third Party Committee’s Investigation Report, which ran to 259 pages and identified where the losses had occurred and the efforts to conceal them, concluding that the case was a ‘complete failure of corporate governance’ and that the entire event ‘has been very unfortunate for the credibility of corporate Japan’.
The report also examined the responsibility of the auditors, and cleared KPMG Azsa LLC and Ernst & Young ShinNihon LLC of culpability for the fiasco, although it has concluded that five current and former corporate statutory auditors are culpable.
While the investigations continue and the legal cases are prepared, the key questions are, what will become of the company and what are the implications for corporate governance in Japan?
For Olympus, the prognosis appears reasonably good.
‘Their losses have now been realised and sorted out, meaning that the black hole in their accounts has been dealt with,’ says a Tokyo-based lawyer. ‘So now the question becomes whether the company can maintain the confidence of the people that deal with it, and in Japan that means the banks.
‘They have to be concerned about their banks as their debts are very high and, if they lose the confidence of Sumitomo Mitsui Banking Corporation then they are in trouble,’ he says. ‘But I don’t think that has happened and I don’t think it will.’
And as far as consumers are concerned, Olympus makes good products and there would only be an impact on retail sales if there was a fear that the company was going under and after-sales service would be affected. At present, that is an unlikely scenario.
So with Olympus likely to survive, perhaps with a capital injection and a potential team-up with another firm, the focus will inevitably turn to how Japan can prevent another failure of corporate governance on such a massive scale.
‘There were two main causes of the scandal,’ says Nicholas Benes, representative director of The Board Director Training Institute of Japan, a not-for-profit public interest organisation certified by the Japanese government.
‘Firstly, the lack of at least three truly independent directors, and a more effective audit committee structure manned solely by them. To say the same thing in reverse, the “statutory auditor” system has some strong points, but overall it is obsolete. The presence of statutory auditors allows Japanese directors to think they do not have to worry much about the financial statements.
‘And secondly, Japan is one of the few countries in the world that has absolutely no rules or accepted practices about director training, either requiring it or requiring disclosure of company policy about it,’ he adds.
Japanese companies promote experienced managers and engineers to their board, but without effective training these people do not really understand their role and are not fully aware of the huge personal liability they are taking on if they are not appropriately inquisitive and sceptical about the actions of the board, Benes explains.
‘They essentially view being a director as just another promotion, that the president and chairman are still their bosses, and it is better to not say much if they want to be promoted,’ he says.
‘Japanese corporate governance has been far too trusting of Japanese managers in an increasingly complex and risky world,’ Benes adds. ‘On average, individual managers in Japan can be trusted at a high level and, unlike some other countries, they are far less led by monetary motives.
‘However, as long as companies and their auditors do not realise that the combination of long-term employment with hierarchical management bureaucracies can easily create dangerous “group-think” patterns, and countervail this with effective external training programmes, new legal rules and structures will continue to have limited positive impact,’ he says.
Meanwhile, Naomi Fink, Japan equity strategist for Jefferies (Japan), says that a proposal by the Ministry of Justice to revise the Companies Act to require large companies to have at least one outside director ‘is not enough’.
‘If made legally mandatory, appointing outside directors would be of symbolic importance, but practically of limited impact,’ she adds. ‘Without a stricter definition of independence, application of the amended law might be watered down.’
And such a change would not have had an impact in the Olympus case anyway, she points out, as the company had no fewer than four outside directors.
Another option that is being considered, according to a source involved in the investigation, is rotation of auditing firms at companies.
Japan’s auditing regulators and the industry are ‘still gathering their wits’ about the most effective steps that might be taken to rebuild the trust of the public and investors, according to Benes, who would like to see ways for his organisation to work more closely with accountancy firms in Japan and groups, such as the Association of Certified Fraud Examiners, to improve training and identify practices that can be improved.
‘In Japan, business is so much about connections,’ says a legal expert. ‘And no one in Japan is going to want to go into a company and be the bad guy because that’s a very un-Japanese thing to do, to upset the group.
‘Looking at Japanese financial statements, they’re immeasurably better compared to 20 years ago,’ he adds. ‘Big companies that list in the US or Europe have moved to tighten stuff up. It’s the smaller, family run companies where I suspect change will take time to come through.
‘There is one school of thought that all this will be forgotten about in six months and people will continue in the same old way,’ he adds.
‘My take is that something will get done. It may not be immediately perfect, but it will be a step in the right direction.’
Blowing the whistle: the theory and the practice
The Olympus story might never have seen the light of day had it not been for the actions of one of those rare creatures of the Japanese corporate world, the whistleblower.
The source of the information that served as the basis for two stories that appeared in the Facta journal, first published on 20 July, remains unknown. Yet Michael Woodford, the former chief executive of Olympus, has paid tribute to the man or woman who provided the damning details of the firm’s operations, describing the original whistleblower as ‘brave’.
‘That person is a hero’, he said in a press conference on 26 November.
New legislation designed to protect whistleblowers went into effect in April 2006, and the question today is whether the attention this case has attracted will encourage more employees of Japanese firms to reveal the wrongdoings of their management, or whether would-be whistleblowers sense it is better to keep quiet.
Corporate governance specialists have expressed concern that, while firms in Japan are paying lip service to the requirement that they enable whistleblowing and protect those who do reveal illegal activities, it seems their employees are not in as strong a position as they are in other jurisdictions.
Britain safeguards ‘protected disclosures’ through the Public Interest Disclosure Act 1998, while the US has the Dodd-Frank Wall Street Reform and Consumer Protection Act, but both have differences to the rules in Japan.
The US act, for example, makes it possible for a whistleblower to receive as much as 30% of the fines levied on a company over US$1m by Department of Justice, after it is found guilty of wrongdoing.
‘There are no incentives for whistleblowers in Japan, so the reason they come forward is because they want the right thing to happen, they are ethical and they don’t want their company to be in the wrong,’ says Nicholas Benes, representative director of The Board Director Training Institute of Japan.
‘Japanese people have a great deal of loyalty to their organisation and hierarchy, but if a person fails to act out of a sense of loyalty and that leads to years of malfeasance, how is that helping the company?’ he asks. There is, he points out, no way of sugar-coating serious wrongdoing, whether that is a firm’s falsification of accounting records or links to organised crime groups or rigging bids.
Despite the lack of incentives, Stuart Witchell, senior managing director of FTI Consulting’s Global Risk and Investigations practice in Asia Pacific, says there has been a gradual increase in the number of whistleblowing cases in the last five years.
‘I would say that the strongest single reason for the gradual increase has been the ‘demonstration effect’ of other individuals taking cases against major companies over mistreatment after whistleblowing and winning their cases in court, although the compensatory amounts tend to be relatively paltry,’ he says.
Yet reports of whistleblowers being ostracised by colleagues will inevitably discourage others, he points out, while the ‘relatively narrow breadth of the current legislation’ – which only applies to private sector employees while business partners, suppliers and customers cannot act as whistleblowers – is another drawback.
But fear remains the single biggest obstacle. In a survey by the Consumer Affairs Agency in October 2010, the most common reason given by employees for not stepping forward was the fear of being on the receiving end of unfair treatment in the workplace.
Some 44% of the 3,000 workers replying to the survey said they would not think of reporting illegal actions within their companies.
Julian Ryall, journalist