In some ways the international financial press has treated the unfolding scandal at Tokyo–based camera and medical equipment manufacturer Olympus as a peculiarly Japanese morality tale, rooted in Japan’s economic meltdown of the 1990s and sustained by a culture of entrenched deference to management. However, the Olympus story is much more than an opportunity for trans-Pacific schadenfreude: the structural weaknesses in the company’s corporate governance that fueled the current crisis are as much a problem for U.S. investors as they are for shareholders abroad.
The crisis at Olympus began in October, when the company’s then–CEO, Michael Woodford, became suspicious of a series of exorbitantly priced acquisitions, and confronted the company’s chairman and executive management. Woodford was summarily expelled from the company weeks later, but his questioning precipitated an investigation which eventually uncovered an extraordinarily long-lived accounting fraud involving a scheme to use over $1 billion in merger payouts to cover up investment losses more than two decades old.
Many details of the scam at Olympus were revealed in a scathing 200-page report issued by a company-commissioned panel on December 6, 2011. Ironically, the fraud was born when Olympus undertook extraordinary measures to avoid the disclosure of losses in the face of Japanese accounting reforms for mark-to-market accounting in 2000 and consolidation with subsidiaries in 2007.
Although the structures of the schemes were complicated, in essence Olympus provided funds to subsidiaries to purchase nearly worthless securities at full book value. It later paid inflated prices for acquisitions and related advisory fees to make up for the hidden losses.
The December 6 report, compiled after interviews with Olympus executives and outside auditors, included a detailed account of who was responsible for the schemes. The panel concluded that a group of top executives had systematically violated the law, concluding, “The core part of the management was rotten, and that contaminated other parts around it.”
The Olympus scandal highlights many areas of reform for Japanese corporate governance that sound familiar to U.S. investors. These include, like in the Enron case, the failure of gatekeepers such as outside auditors and also those financial advisers who knew that the schemes they promoted were being used for illegal purposes. Other reforms might include a more open and transparent system for selecting companies’ top management and a more robust system for shareholder litigation.
However, the biggest issue in the Olympus case is the virtual paralysis of its board of directors, which should have acted as the first line of defense against management malfeasance. The indictment of Olympus’ board in the December 6 report came as something of a surprise, since Olympus had three outside directors on its 15-member board. Indeed, Olympus was considered to have a relatively good corporate governance structure, since roughly half of Japanese listed companies still have no outside directors.
The problem, as the report pointed out, was that those outside directors were essentially powerless. One key reason why outside and independent directors in both Japan and the U.S. lack the ability to meaningfully oversee management is their limited access to information much more readily available to corporate insiders. As a result, outside and independent directors often find it difficult to voice concerns or ask questions in the presence of insider directors and executives with far more knowledge about the company’s business.
This problem is hardly endemic to Japan. As seen in Enron and other recent U.S. corporate scandals, independent directors in the U.S. have repeatedly failed to provide effective oversight for corporate executives that have been deeply engaged in illegal or unethical practices. However, little has been done here or overseas to ensure the quality and completeness of the information provided by management to independent directors.
The adequate flow of information from corporate executives and inside directors to independent directors is the key to a functional board. Independent directors should have access to timely, complete and accurate information provided by management and by inside directors.
At the same time, independent directors owe shareholders a duty of inquiry, to take the initiative to gather information from the officers, managers and employees who possess the information that they need. Their sources of information should not be limited to the top management, because CEO control over information channels may undermine the directors’ ability to receive complete and accurate information, thus giving the CEO the power to dominate the board. Instead, the directors should be able to access relevant information from different sources at all hierarchical levels, within and outside the corporation.
Until boards and investors in both Japan and the U.S. take the issue of access to information seriously, independent and outside directors will be hamstrung in their core responsibility to police corporate management on behalf of shareholders. It remains to be seen whether the scandal at Olympus will provide the wake-up call that has long been needed.
Michael W. Stocker is a partner with the law firm Labaton Sucharow. He represents institutional investors in securities, regulatory, and corporate governance matters.
Bruce Aronson is a professor of law at Creighton University School of Law. He specializes in comparative corporate governance and is currently a Senior Fulbright Research Scholar at Waseda University in Japan.
Yoko Goto, an associate at Labaton Sucharow, contributed to this article.
