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A rotten heart

26 October 2015

A rotten heart - Read more

Japan’s culture of obedience is at the centre of the Toshiba scandal

Shockwaves from the Toshiba accounting scandal are still being felt. Current and past presidents have resigned, as has half the board of directors. The share price is significantly down and the company has been expelled from Japan’s Nikkei 400 Index – an index launched last summer and composed of companies chosen for their appeal to investors and standards of good governance.
The Toshiba scandal has been a blow not just to the company, its directors, employees and shareholders but also to the Japanese president Shinzo Abe and his attempts to reform the country’s corporate governance practices. A recent study of corporate governance in 25 leading nations by KPMG and ACCA placed Japan 21 out of 25, the lowest of the developed countries and behind Indonesia, Russia, Brazil, Cambodia and China.

Underperformance

A lack of supervision of Japanese senior management is believed to contribute to chronic underperformance. Japanese firms in the TOPIX 500 index had an average return on equity in 2012 of 7%, compared with over 15% for American and European companies.

In a bid to make Japanese companies more attractive to overseas investors in order to boost growth, the Abe administration launched a new corporate governance code just six weeks prior to the Toshiba collapse. Under the new code, introduced on a ‘comply or explain’ rather than a mandatory basis, companies are asked to appoint at least two independent directors, promote open dialogue with shareholders, adopt a whistleblowing policy and address issues such as gender diversity and social and environmental responsibility.

Leading the field

The Toshiba story is particularly shocking because the company was once widely applauded for its corporate governance. Toshiba first appointed external directors back in 2001, long before the Olympus scandal and at a time when Japanese boardrooms were dominated by long-standing company insiders. In 2013, Toshiba was ranked ninth out of 120 publicly traded Japanese companies for good governance practices, in a list compiled by the not-for-profit Japan Corporate Governance Network.

How could a company that appeared to be leading the field in good corporate governance find itself at the centre of one of the country’s biggest ever accounting scandals? Although much can be laid at the door of Japanese corporate culture, there are nonetheless universal dangers that any senior management team should heed.

Looking at board composition, four of Toshiba’s 16-strong board were outsiders, which though uncommon in Japan, is short of best practice requirements elsewhere in the world. However, selecting external directors is more than just a numbers game. To act in the best interests of shareholders and, as is increasingly acknowledged, to act properly as company stewards, they must be experienced and genuinely independent. Three of the four independent Toshiba directors had little business training and would appear to offer more in the way of box-ticking than corporate accountability.

A culture of obedience

Although the Abe government has set out to encourage greater boardroom rigour, the yes-men culture still dominates. Michael Woodford, the whistleblowing president of Olympus, described the board as ‘children in a classroom’. Such unquestioning obedience and loyalty permeates Japanese corporate culture and can be said to be at the heart of the Toshiba scandal. Although no explicit instructions were given by senior management to fiddle the accounts, the falsification occurred as a result of impossible targets, which lead to employees lower in the hierarchy doing whatever it took to meet them. The more targets were met, the more impossible they became, creating an unstoppable pattern.

This false accounting began under Atsutoshi Nishida, chief executive between 2005 and 2009 and a Toshiba advisor until the scandal broke. According to the investigating panel, in 2008 Nishida heard that the company was heading for a loss of ¥18.4 billion and declared the figure ‘so embarrassing we cannot announce it’. As a result, his subordinates doctored the numbers to a profit of ¥500 million. Nishida claims to have been unaware of what was going on, however, given that Toshiba’s corporate culture prevented employees from going against the will of their superiors, it is easy to see how the irregularities began following the delivery of such a statement.

Weak auditing

In addition to its corporate culture, the Toshiba case has also brought Japan’s auditing practices into the spotlight. Although EY ShinNihon could be expected to take its share of the blame for failing to note the irregularities, the presence of Toshiba executives on the audit committee would also raise a red flag in most governance circles.

Questions are also being asked about whether the notoriously low fees paid to the auditors of Japan-listed companies mean insufficient time is spent scrutinising accounts. Historically, auditing fees were capped in Japan and although these limits were lifted over a decade ago, fees have struggled to reach the levels paid in other developed markets.

Analysis by GMT Research in Hong Kong of more than 2,300 listed companies with sales of US$500 million or more, found that Japanese firms pay their auditors on average 3.2 basis points of turnover compared with 5.3 in Britain and 11.8 in the US. The overall international average was 5.6 but the six-year average at Toshiba was 1.8.

Auditor independence is also called into question. Auditors need to remember that they are working for company shareholders as well as for society to maintain its trust in publicly traded companies. This can only be done successfully if genuine independence from management is maintained, necessitating a clear division between auditing activity and consultancy services. As long as auditors continue to make money providing consultancy services, tax and corporate finance advice to their audit clients, there is a risk that the audit itself will lack proper independence and management scrutiny.

Radical cultural change

Toshiba, like Olympus before it, must go through a radical management shake-up and develop a culture where there is genuine challenge from independent non-executive directors. There must also be a speak-up culture allowing managers and employees to raise concerns. The new corporate governance code in Japan has been amended to offer greater guidance on whistleblowing procedures. Companies are encouraged to establish a framework that allows employees to report misconduct without fear of reprisal. Most significantly, the code states that the whistleblower point of contact should be independent of management, ideally a panel consisting of outside directors and outside statutory auditors.

Toshiba has already stated that it will appoint more outside directors. However, the first test will be how the new chairman is appointed. Traditionally in Japan, the outgoing boss appoints his successor. When Atsutoshi Nishida stepped down, the board was by-passed. Even in the UK the real independence of the chairman is debatable as it is a role often given to the former CEO as a stepping-stone to retirement.

It will be interesting to see whether the firm will conduct a fair and transparent nomination process to appoint Mr Tanaka’s successor.

Leo Martin is Director and Co-founder at GoodCorporation

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