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Hugh Young: The rise of corporate governance in Japan

Hugh Young

The scandal at Japanese optics and healthcare company Olympus in 2011 served to highlight the historically poor standards of corporate governance in Japan. Olympus’s then British chief executive Michael Woodford became whistleblower, revealing a £1.1bn accounting fraud he alleged had been taking place since 2006.

Woodford was fired because he wanted Olympus to come clean about questionable acquisitions, none of which had been reported in the company’s financial statements. Within a month of his departure, Olympus’s share price had fallen 82 per cent and $7bn had been wiped off the company’s value.

The Olympus scandal may have appeared to be an outlier until news of the £750m Toshiba fraud broke in July this year. Once again, top management were complicit in accounting irregularities to boost profits. Toshiba’s chief executive and vice-president were accused of creating a pressurised corporate culture that encouraged management to falsify figures to meet targets.

But amid the scandals, it is worth remembering that there have been several positive developments in corporate governance standards in Japan. Indeed, the country’s first corporate governance code, out in June this year, is the latest in a series of developments that suggests things may be changing. The code seeks to hold companies more accountable to shareholders.

What is more, the degree of consensus on the need for corporate governance reform has been encouraging. The guidelines draw on the Organisation for Economic Co-operation and Development’s Principles of Corporate Governance but are “tailored” for Japanese companies.

An example of these guidelines is for companies annually to examine and justify cross-shareholdings, which may threaten the cosy business relationships that have been a defining feature of corporate Japan.

The code also requires firms to appoint at least two external directors, in a bid to shake up compliant corporate boards. As with earlier corporate governance-related reforms, the code is voluntary. However, what gives these measures some teeth is the fact that Tokyo Stock Exchange listing rules require companies to comply with these guidelines or provide a decent explanation for their failure to do so.

In truth, the reform process has been in train for more than two years. In August 2013, the Japanese Government published a report that recommended ways to improve the relationship between companies and investors. The recommendations included encouraging companies to improve capital efficiency through targeting a return on equity of at least 8 per cent.

Echoing concerns expressed by shareholders on capital allocation, the review noted investors’ preference for “…reserves to be returned to shareholders in the event that they cannot be effectively put to work”, while recommending better engagement between investors and companies.

Another development that aims to embed the notion of shareholder value was the JPX-Nikkei 400 index, a new benchmark conceived as a way of highlighting better-performing companies through metrics valued by shareholders. Companies’ scores on ROE, three-year cumulative operating profits and market capitalisation, determine whether they are included or not. Companies are also assessed on the appointment of outside directors, adoption of International Financial Reporting Standards and whether they disclose information in English. The index has proved useful in spurring firms into action.

It is notable that other large-scale frauds – Volkswagen in Germany and Enron in the US – occurred in countries with very different views regarding the role of the corporation in society than Japan. Ultimately, there is no single perfect system of corporate governance. Each country and company’s system is a function of its history, laws, customs and social environment. This is particularly true in Japan.

There are some absolutes, though. Companies should always have strong management, clear strategic direction, a collaborative culture and effective risk management.

Poor standards of corporate governance are a clear red flag. The good news for investors in Japan is that the Government and companies themselves are taking concrete steps to improve their standards in this area. The furore over the Olympus and Toshiba scandals will only serve to accelerate this trend.

Hugh Young is managing director of Aberdeen Asset Management Asia


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