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Kenichi Osugi

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Can Corporate Scandals be Prevented by the Companies Act Reform ?

Kenichi Osugi
Professor of Commercial Law, Corporate Law, Securities Regulation, Chuo Law School

Theme

From September through November 2011 a series of corporate management scandals came to light in Daio Paper and Olympus. According to reports, in the Democratic Party, the ruling party of Japan, an opinion is gaining momentum that now is the time to strengthen regulations, such as the mandatory appointment of external (independent) directors. On the other hand, there are also more than a few commentators who contends that these companies are the exception and that these scandals do not represent a systemic problem, but rather an issue of managerial ethics of the particular managers and auditors.

However, these are both extreme points of view; it is necessary to consider this issue in a well-balanced manner. Of course, the law is not omnipotent and it is impossible to eradicate all scandals with revisions to it. Seeking to argue that the only cause is individuals who lack the sense of morality is to trivialize the problem. Imagine you are in a position in a Japanese company and you happen to know that top management in the company may have been involved in a scandal, can you be brave enough to take appropriate actions to either make sure if that is the case, or inform your colleagues of your knowledge? There is by no means a majority of people who can suppress favoritism and determine matters of ethics in a setting where favoritism and ethics are antithetic, as has already been pointed out in a blog posting by lawyer Toshiaki Yamaguchi (see the article on December 5 and 12, 2011, on Bijinesu Homu no Heya [in Japanese]). Facing a couple of corporate scandals, we should now inspect to see whether the concerned people are willing to act ethically in the existing system. If we do not believe they are, we should then look at things with a perspective toward revising the law.

Accordingly, in the following, I shall give an overview of the two scandals and then, upon reviewing the essence of current law, I would like to argue for how law and other rules should be revised.

The Case of Daio Paper

According to the report of the Special Investigation Committee published on the website of the company, the former president, a third generation member of the founding family, instructed the managing directors of the company's seven subsidiaries to "transfer XXX million yen into [his] account by tomorrow." Across a total of 26 separate occasions during the period from May 2010 through September 2011, a sum total of over 10 billion yen was lent from these subsidiaries to the former president. These loans were set aside for the former president's entertainment expenses. This is simply a crime of self-desire, with little organization to it.

In law, on occasions when directors, corporate auditors [Kansayaku in Japanese] or auditing firms receive information where there is suspected fraud or misfeasance, they must communicate the fact with each other (Companies Act, Article 357, Article 382, Article 397 and Financial Instruments and Exchange Act, Article 193-3). Corporate auditors and auditing firms can demand that directors and employees provide the information necessary for auditing (Companies Act, Article 381 and Article 396). In auditing standards that have been enacted by the Japan Corporate Auditors Association [in Japanese]new window, it is strongly recommended that a corporate auditor cooperate with the auditing firm and the internal controls department of a company, for instance, through occasions for periodic discussions among those parties (Article 34 and Article 44, inter alia).

However, according to the investigation report, there was insufficient cooperation among the auditors, auditing firm, accounting department and operations department in Daio Paper; periodic meetings have rarely been hold. Therefore, some of the directors and the auditing firm were aware that some of those loans had been made at a relatively early stage but did not inform other directors or corporate auditors of it. In short, they did not properly uphold the spirit of the law.

The Case of Olympus

The independent committee investigation report into Olympus (published on the company's website) also points out some interesting facts.

According to the report, the management made speculative investment in shares in other companies during the bubble economy of the late 1980s, as other large companies in Japan did, which caused large losses to the company after the collapse of the bubble. This led the management to invest in even riskier companies and financial instruments in the 1990s in view of possible higher return to recover these losses. As a result, the losses grew dramatically. Since the end of the 1990s, a movement for fair market valuations of financial assets has been proceeding at full steam following changes to accounting standards. The managers in the financial department of the company, obsessed with necessity of covering up the losses, invented a complicated plan, with the cooperation of outside specialists, which made the losses hidden in offshore investment funds (so-called "Tobashi"). With approval from the (then) president on the plan, they carried it out. On the other hand, from 2003 through 2010, with the approval of the (then) president, the managers in the financial department intentionally structured mergers and acquisitions with inflated amounts of money with the cooperation of external parties, who received padded commissions. The bloated portion of those M&As' price and commissions were circulated secretly to the offshore funds, with which the hidden losses were offset and ultimately eliminated. After those transactions, those inflated expenses were amortized either regularly in several years or in a shorter period as booking of impairment losses in the company's accounts, and thus, the books were balanced.

The acts of concealing losses and secretly processing losses both constitute a creation of a false financial statement (window dressing accounting) and are in violation of the Financial Instruments and Exchange Act. These illegal acts differ from the situation at Daio Paper in that these actions were done not to fill the pockets of the directors involved in the affair, but from a belief that it would be impossible to inform those outside the company of the losses. Nevertheless, that doesn't mean we should feel compassion for them. A false financial statement allows the managers of the company to obscure their accountability to the investors. In other words, it was a form of self-protection, and thus, it is still to be strongly condemned.

Well then, would it have been possible for those persons who were around the "main culprit" to detect even earlier these illegal acts? In regards to the hiding of losses via the above-mentioned Tobashi scheme, it might have been discovered if the auditing firm had made more thorough inquiries; it could have question the foreign banks where Olympus had opened accounts about whether any collaterals were attached to the deposits. However, it is not certain at this moment whether the auditing firm was at fault for not doing this; it might be that the fraud was ingenious. On the other hand, according to the investigation report, in regards to the processing of losses through mergers and acquisitions, the auditing firm, having suspicions about the price of the transactions and commissions, communicated these suspicions to corporate auditors. Nevertheless, the board of auditors did not take the issue seriously; it hired some experts outside of the company and let them say the prices were reasonable. Because of this, the auditing firms could not delve any further than they already had into this problem. Moreover, it appears that only superficial conversations were made in the handover that took place between the old and new auditing firms when there was a switch in auditing firms in 2009. It is not possible to make a definitive judgment on the corporate auditors and the auditing firms about their failure to act better, but there is a suspicion that they were at fault.

Analysis of the Current System

What is common to both Daio Paper and Olympus is that there were employees who knew about the improprieties that were taking place (it is said that the discovery of the Olympus incident was triggered by complaints to the media by employees) and that the auditing firms had also gotten hold of information that suggested misfeasance was taking place. Nonetheless, this information was not widely shared between directors and auditors, and few investigations took place.

Then, what is the best way to deal with this problem? At present, revisions to the Companies Act are being considered in the Legislative Council of the Ministry of Justice, Companies Act Subcommittee (an advisory body to the Minister of Justice). For example, they are debating whether to require listed companies to appoint at least one external director(see the Interim Draft Plan on Revisions to the Companies Act [in Japanese]new window). However, even if, for argument's sake, there had been external directors in Daio Paper or Olympus, it is difficult to conclude that this by itself would have led to the early detection of the problems in these companies (actually there were three external directors in Olympus, but the firm's window dressing accounting was not uncovered for a long time).

After looking at these two cases, I have come to believe that it is external auditors who should act decisively when facts suggesting improprieties come to light, and that in fact, it is usual that little information is passed on to these external directors and auditors, so that cooperation with the relevant parties rarely works. In a one-on-one confrontation by corporate auditors or people from the auditing firm with managers, they can hardly speak out at a meeting. In order for them to do so, it is necessary for those relevant parties to cooperate with each other and to confront the managers in a many-on-one fashion. For example, so that employees who know of improprieties can feel safe in reporting these facts, it is very important to set up a point of contact for reports outside the company and to build a structure where this information is also communicated to external auditors (see the December 5, 2011 blog post of the aforementioned lawyer Toshiaki Yamaguchi [in Japanese]). This should be done in the first instance through voluntary efforts at each company, but in order to ensure cooperation among the related people with a focus on external auditors, it would be effective to elevate the authority of these external auditors and to dilute the power of the top management in companies.

Proposals for Improvements

I would like to make the following proposals for improvements. My first proposal is that while the current external auditors should maintain the authority which they currently have as corporate auditors (such as the authority to investigate facts: Companies Act, Article 381 and the authority to enjoin illegal activities of the directors: Article 385), there should be changes in the law so that at the same time they may hold the legal as well as de facto authority as directors. "Kansa-Kantoku Iinkai" (committee for audit and oversight) which is debated in the Legislative Council of the Ministry of Justice can be an attempt along these lines.

My second proposal is that nomination and remuneration, especially the nomination of the chief directors, should be determined by a committee in order to avoid the concentration of power in the top management of the company. (In Olympus, personnel in the accounting department involved in the misfeasance were promoted within the company, to the chief executive officers as well as a full-time corporate auditor. This was probably due to the intentions of the top management in each period.) However, it is not necessarily essential to impose legal requirement of nomination and remuneration committees on listed companies as on current companies with three legal committees. It would also be best to entrust to the devices of each company the membership structure of their committees and the method of their decision-making processes. If we consider this, there should be an obligation regarding nomination for the chief executive officer and other chief officers and other directors, not by the Companies Act, but through listing rules of stock exchanges.

Laws or Listing Rules

When considering imposing obligations on listed companies, a very important point is whether this should be achieved through laws or through listing rules of stock exchanges. In regards to corporate governance, there are a variety of issues which are not dealt with by law, but rather fit in with listing regulation.

Entrusting all rulemaking to stock exchanges would be difficult, since they are private business operators. Thus, it is appropriate that the fundamental principle be established in law (Companies Act); for instance, "external directors shall oversee the executive managers in listed companies". In addition, when stock exchanges think of making revisions to stock listing laws accordingly, it would be of great help if administrative agencies, such as the Financial Securities Agency and the Ministry of Economy, Trade and Industry, back this up.

Kenichi Osugi
Professor of Commercial Law, Corporate Law, Securities Regulation, Chuo Law School
Born in 1967 in Hyogo Prefecture. In 1990, he graduated from the Faculty of Law, University of Tokyo. He worked as a research associate at the University of Tokyo and then as an associate professor in Tokyo Metropolitan University. Since 2004, he has been in his current position.
He conducts research on contemporary issues in corporate law, for example, on venture businesses, business restructuring, corporate acquisitions (mergers and acquisitions) and corporate governance. His publications include, Corporate Law: Second Edition (in Japanese, coauthored with Yasushi Ito, Wataru Tanaka and Hideyuki Matsui; Yuhikaku, 2011), The Relationship Between Corporate Law and Financial Regulations with Other Business Regulations, in the Horitsu Jiho , Vol. 82, No. 12 [in Japanese] (2010) and Recent Reform of Japan's Corporate Law in an International Context: Who have Participated in the Reforms, and How? in the Japanese Yearbook of International Law Vol. 53 [in English] (2010).