Reining in a Culture of Fraud: Adopting Incentive-based Regulations to Reform Corporate Governance in Japan

• Publication year: 2016

Reining in a Culture of Fraud: Adopting Incentive-Based Regulations to Reform Corporate Governance in Japan

Kevin Engelberg

Reining in a Culture of Fraud: Adopting Incentive-Based Regulations to Reform Corporate Governance in Japan

Introduction

On July 21, 2015, Toshiba's CEO Hisao Tanaka announced that he was resigning from the corporation to take responsibility for his involvement in an accounting scandal that caused Toshiba to overstate its profits by approximately $1.2 billion USD.¹ The fraud resulted from of a top-down effort by Toshiba's employees to inflate the company's net income.² Top executives at Toshiba set almost impossible profit targets, and pressured employees to meet those targets by any means, including the fraudulent inflation of profits.³ A lack of internal controls, combined with a corporate culture that demands strict obedience to management decisions, resulted in a fraudulent inflation scheme spanning over a seven-year period.⁴ The scandal was ultimately uncovered when Japan's securities watchdog, the Securities and Exchange Surveillance Commission ("SESC"), launched a probe into Toshiba's accounting practices and discovered the misconduct.⁵

Toshiba's fraudulent accounting scandal was not an isolated incident among Japanese corporations. A multitude of accounting fraud scandals regarding overstating profits have occurred in Japan: the Olympus Corporation for $1.7 billion USD in 2011, IHI Corp. for $4.6 billion USD in 2007, Nikko Cordial Corp. for $13.7 billion USD in 2006, and Kanebo Ltd. by 210 billion Yen in 2004.⁶ Accounting scandals, like the above mentioned, have serious economic implications on companies and investors.⁷ It is not unusual for such

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companies to be forced into bankruptcy, causing many investors to lose significant financial worth.⁸ Clearly, financial statement fraud has adverse effects on shareholders and must be stopped. However, these instances of corporate misconduct are symptomatic of Japan's record for poor corporate governance.⁹ Accounting fraud is only one of many negative aspects stemming from Japan's poor corporate governance regulations, and the lack of corporate oversight has negatively impacted Japan's overall economy.¹⁰

According to the International Monetary Fund ("IMF"), there is a strong link between the quality of a country's corporate governance regulations and the overall health of its economy.¹¹ The IMF attributes Japan's weak economy to its lack of corporate governance.¹² Specifically, in this case, these poor corporate governance practices link directly to the abnormally high cash holdings by Japanese companies.¹³ In 2015, The Economist reported that Japanese companies were holding $1.9 trillion USD in cash, an amount equivalent to almost fifty percent of the entire Japanese economy. ¹⁴ This alarmingly high figure suggests that the lack of corporate governance practices is a large factor contributing to a stagnation of funds amounting to nearly a half of the Japanese economy. Thus, improvements in Japan's corporate governance regulations may not only reduce corporate malfeasance but could potentially spur economic growth.

I. Japanese Culture and Business

In order to understand why the above corporate governance reform efforts are necessary, it is important to understand how the current top-down culture facilitates Japanese corporate misconduct. Although Japanese public corporations, for the most part, mirror public corporations in the United States (i.e. they have shareholders, a board, and corporate executives), Japanese companies tend to be much more responsive to the demands of their corporate

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executives than their shareholders.¹⁵ This skewed interest in favor of corporate executives is influenced by the Japanese tradition of 'makoto'.¹⁶ Makoto means to "properly discharge all of one's obligations so that everything will flow smoothly and harmony will be maintained" above everything else, even truthfulness and honesty.¹⁷ It is based on the belief that social harmony is best achieved through conformity and obedience to authority.¹⁸ In a workplace setting, makoto can create a leadership command chain similar to a military hierarchy: the top executives give the orders and all lower level employees are expected to obediently follow them.¹⁹ Understanding such values reveals how corporate accounting frauds can go unchecked over the course of several decades.²⁰

In the Japanese business community, subordinate employees are expected to demonstrate a deep level of commitment and loyalty to their corporate managers.²¹ Under the principles of makoto, it is disrespectful for an employee to speak or act outside the scope of his or her prescribed position.²² This belief system prevents many individuals from challenging the decisions of their superiors, and discourages them from disclosing any problems that may arise.²³ In return, superiors will often reward their most loyal employees with respect, appreciation, and even promotions.²⁴ Thus corporate managers are able to consolidate their power by surrounding themselves with employees who are committed to following their orders.

In addition to the values of makoto, Japanese ideas of cultural harmony also play a big role in facilitating corporate misconduct. At its core, cultural harmony can be best described by the Japanese proverb, "the nail that sticks out gets hammed down,"—meaning that its better to follow the group than to stand out²⁵ Thus, "groupthink" dominates Japanese corporate culture.²⁶

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Oftentimes, employees will use groupthink to rationalize the validity of impermissible acts by concluding that other employees exhibit the same behavior.²⁷ Under such cultural norms, widespread corporate fraud is easily achievable and oftentimes goes unnoticed.

The traditional Japanese values of duty, authority, and harmony are so highly valued that individuals are taught to avoid disrupting social tranquility.²⁸ Thus, it is easy to turn a blind eye to corporate governance conflicts in order to avoid upsetting or destabilizing the social environment.²⁹ These cultural concepts and beliefs provide insight as to how the Olympus accounting fraud, Japan's largest known accounting scandal, persisted for almost two decades.³⁰

II. The Olympus Accounting Scandal

To date, Olympus is Japan's third largest accounting scandal.³¹ Over the course of twenty years,³² Olympus was able to hide approximately $1.7 billion USD in losses from investors.³³ The scandal stemmed from the management's policy of demanding that overly aggressive profit targets were met.³⁴ Unable to meet these excessively high targets, employees set up complex schemes to accelerate profits and bury losses, even using outside consultations for the sole purpose of financial statement fraud.³⁵ The fraud persisted for 20 years, and not one whistleblower came forward.³⁶ Viewed under the cultural principles described above, it is understandable why such practices continued for a longtime.³⁷

In the case of Olympus, former CEO Tsuyoshi Kikukawa held all the power to control the company.³⁸ contrary to public companies in the United States, board members and executives in Japan do not have clearly distinct

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spheres of power.³⁹ This lack of power separation essentially allowed Kikukawa to act as both the President and Board Chairman of Olympus, providing him with unlimited authority to make all personnel decisions, even at the Board level.⁴⁰ Kikukawa promoted only the most loyal employees to the Board, essentially rendering the Board ineffective.⁴¹ The Board became beholden to the CEO to such an extent, that an investigative report revealed the Directors were merely "emasculated" company "yes-men."⁴² All demands for greater profits, regardless of feasibility, were met using any means necessary, including the inflation of financial figures in a display of loyalty.⁴³

When Kikukawa demanded greater profits, his inferiors were all too willing to meet those targets by any means necessary.⁴⁴ In a display of both loyalty and social harmony, employees made a concerted effort to inflate financial figures.⁴⁵ Employees' overriding instinct was to hide any and all mistakes regardless of the costs.⁴⁶ Company loyalty was so great that no one ever bothered to blow the whistle or criticize the actions.⁴⁷ Olympus fell victim to groupthink.

After two decades of deceit, the Olympus scandal was discovered when Michael Wood, Olympus' first non-Japanese CEO, become a whistleblower.⁴⁸ Wood became suspicious after witnessing an employee attempt to hide a newspaper article that alleged Olympus had engaged in corporate misconduct.⁴⁹ Wood launched an internal investigation, and upon discovering the fraudulent acts by former CEO and current Chairman of the Board, Kikukawa, Wood demanded letters of resignation for all board members.⁵⁰ The following day, Kikukawa promptly retaliated by firing Wood.⁵¹ The Olympus case demonstrates two major problems that Japanese corporate governance regulations must address: (1) the consolidation of power into a single individual, and (2) the feverous loyalty of subordinate employees.

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In fixing these two major issues in Japanese corporate governance, reform must: (1) separate power between board and executives; (2) incentivize executives to maximize profitability for their company; (3) adequately compensate and protect whistleblowers in order to encourage people to report misconduct. The passage of Japan's very first comprehensive corporate governance code is the first sign that Japan may be moving towards this direction. However, more needs to be done to make the code a cornerstone of Japanese corporate governance.

III. The New Codes: An Attempt at Reform

In previous years, any attempt at reforming Japanese corporate governance was met with strong opposition by powerful business executives lobbying to maintain the status quo.⁵² Despite significant pushback, Japan was recently able to implement two landmark...