Blurry Images: Investors, Regulators, Auditors Missed Olympus Warning Signs

It is alarming to note how much has transpired in the past month at Olympus Corporation in Japan. According to published reports, Michael Woodford, the ex-CEO of Olympus, began an investigation of the company’s records. This has unearthed a lot of information relating to the exorbitant advisory fees for the purchase of Gyrus; acquisitions of three obscure companies in 2008; and the subsequent write-down of 76 percent of its value within nine months.

Unfortunately, this has been a revelation not only to the public but also to the institutional shareholders of Olympus. Olympus’ stock price has plummeted since October. Nippon Life Insurance Co., the largest shareholder in Olympus with a stake of 8.2 percent, called for prompt action from the company to allay investors’ worries. Non-Japanese institutional investors like Southeastern Asset Management, a major U.S. shareholder, and Harris Associates L.P., a Chicago-based investment company, are waking up and questioning the series of acquisitions made in 2008, Olympus’ valuation, and the treatment of amortization of goodwill in 2009. Southeastern Asset Management has demanded the resignation of the entire board. Olympus shareholder Baillie Gifford & Co., a U.K. asset manager, has called for a thorough clean-up and wants to reinstate Michael Woodford.

Given the large amounts involved in the amortization of goodwill and the commission fees to Gyrus, investors arguably should have raised these red flags a little earlier. Why didn’t they question the board before the diversification into unrelated obscure businesses? Didn’t any of the analysts covering Olympus stock spot the issues relating to the financial advisory fees and the treatment of goodwill?

It is a mystery as to why KPMG Azsa did not qualify the report in 2009. The auditor simply disagreed with the way Olympus accounted for its 2008 acquisition of Gyrus and the treatment of the financial advisory fees, and resigned (or was replaced by Ernst & Young ShinNihon, as Olympus puts it) as auditors. Did the auditors do their duty in good faith to ensure that the books gave a true and fair view of the state of affairs at the company? What was the role of an audit committee which had two outside corporate auditors? What was the extent of information KPMG Azsa provided E&Y ShinNihon when it took over as auditors in June 2009? If the auditors had worked more diligently and questioned the accuracy of accounting to reflect the true financial position of the company, the alarm would likely have woken up Japanese regulators years earlier.

The police and regulators, including Japan’s Securities and Exchange Surveillance Commission (SESC), are collaborating today to investigate the cover-up of investment losses, and whether it was an accounting fraud or malfeasance, or another case of hiding losses in a “tobashi” scheme. The Tokyo Stock Exchange has put Olympus on watch for a possible delisting. On 11 November, Japan Minister of State for Financial Services Shozaburo Jimi issued a press statement on the matter.

He urged Olympus, on its own initiative, to explore what has actually happened as soon as possible and promptly disclose accurate information, including the investigative findings of the third-party committee, established by the company earlier this month. He further reiterated that the Financial Services Agency of Japan (FSA) is determined to move quickly, in close cooperation with relevant bodies including the Tokyo Stock Exchange, to urge the company to take steps to accurately grasp the truth and make timely disclosure.

The Olympus scandal has rekindled concerns about corporate governance in Japan, particularly the effectiveness of outside directors. It is unclear whether the board approved the purchases with the presence of all three outside directors including Nobel Laureate economist Robert Mundell. Investors would like to see an inquiry into how the directors — especially the three outside directors and two outside statutory auditors, including one independent statutory auditor registered with the Tokyo Stock Exchange — have fulfilled their duties to shareholders.

CFA Institute has published a report, Independent Non-Executive Directors: A Search for True Independence in Asia, in which we have highlighted that board composition and independence are fundamental issues in corporate governance, especially in Asia, and how investors should educate themselves on what true independence means.

The design and functioning of corporate governance systems have a strong impact on the decisions of individual and institutional investors. Valuation falls when investors see that a company has not been acting ethically. It is beyond doubt that clear directions and patterns of reform have to emerge to fix the deficiencies and dysfunctionality of the Japanese system of corporate governance and to reinstall investor confidence. The role of different stakeholders in a corporate governance system is also critical to the proper functioning of that system. It takes investors, analysts, and auditors to demand transparency and accountability to ensure that there is fairness and responsibility.