#corporategovernancecode

Kobe ‘Steal’ – why this scandal could get much uglier

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Kobe Steel is the next in a growing list of Japanese corporates embroiled in data falsification. Kobe Steel has been supplying lower spec material to customers than advertised. In a sense stealing. Sure VW is no better in lying about its emissions but Kobe Steel has the potential to be more like Takata than Mitsubishi Motors in terms of impact. The issue here has to do with Kobe Steel products being in structures of aircraft, trains (including bullet trains) and cars. While much is being made of ‘little risk’ attached to these slightly lower spec products the reality is that ‘metal fatigue’ is calculated in the resesearch, development, testing and evaluation of such products.

For instance when planes are in the development phase FAA certification depends on making sure products can meet certain tolerances, cycles and stress tests. Once certification is granted, if subsequent production is met by sub-standard intermediate products unbeknownst to the manufacturer of the part then the trail becomes a much more serious matter. It is easy enough to determine which Honda’s had defective airbags as it is a specific part on specific models. Yet Kobe Steel steel products shipped all over the globe may have been used in different parts. Then those discrete parts would need to be traced to the next intermediate stage and then on to the finished part to which may be fixed to an airline on the other side of the world. Boeing is naturally not raising any alarms until they can assess the issue.

JR has already noted 310 sub standard parts in wheel bearings in its bullet trains which will be replaced at the next scheduled service. It is likely that the JR parts are over spec for the extra margin of safety.

None-the-less aircraft could turn into a much bigger problem. There is only one spec that is supposed to be met. Failure to meet it could cause planes to be grounded until parts are replaced. This could be massively costly as planes not in the air earning money cost millions on the ground. Not to mention the risk of the US government fining the company for reckless behaviour.

Kobe Steel has seen revenues track sideways for the better part of a decade. Profits have been all over the shop. Much like Toshiba tried to fiddle the books with one division in the hope that in time it would be able to put the money back and no one would notice. As for Kobe Steel, there was obviously a plan to try to boost profitability by lowering specs and charging prices for superior spec. Even then the contribution has been poor. Hardly surprising when the cash conversion cycle has exploded from 38 days a decade ago to around 82 today. To be faker most of the big steel companies have a similar CCC which hasn’t changed much over the last decade.

What we can be pretty sure of will be the soft touch of the local authorities. Even with such willful deceit, it is unlikely anyone will see inside of a jail cell or pay multi million dollar fines in Japan. However the tail risk here is the likes of Boeing who will extract every pound of flesh with the help of its authorities to rent seek from Kobe Steel if certain parts are found to be ultimately faulty because of negligence. This is not a staged Nissan-Mitsubishi Motors leak to force a cheap entry into the latter. Still, 37,000 employees at Kobe Steel will be seen as a sizable number to protect at a national level hence a limp wristed response to follow.

One final point. Do we honestly think that Kobe Steel can conduct an honest audit of its deceit? Surely flagrant data fiddling will be milled down to more acceptable cheating.  It is a time honored tradition to leak a bit, then a bit more so as to minimize the shame.

Until Japanese listed corporates face far harsher penalties for such malfeasance, it will be hard to shake off the cynicism that the corporate governance code has introduced anything more than mere lip service. That is OK if that is what Japan wants to project to the world that shareholders are not a priority.

Corporate Governance in Japan & our talks with the FSA & JPX on changes for 2017

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2017 Report

In our report of August 2015 it was made clear that “NO corporate governance code is perfect.” However, the emphasis was that corporates needed to focus on the quality of independent directors rather than submit to a quantitative box ticking exercise when it came to complying with the new corporate governance code (The Code). While the Tokyo Stock Exchange (JPX) can be rightfully pleased with the progress of compliance by listed entities, when looking through the data, there appears a concerted effort by corporates to employ independent directors with a bent on not upsetting the status quo. That would appear at odds with the spirit of The Code.

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We made clear that the introduction of the Sarbanes Oxley Act (SOX) and other corporate governance codes – which pushed for more independence on boards to ensure fiduciary duty to shareholders – did not prevent investor losses hitting all-time records. Good corporate governance is about building a culture of trust (both inside and outside the boardroom). We have been fortunate to spend ample time with the Financial Services Agency (FSA) and JPX discussing the potential revisions to The Code. We have put forward three suggestions to increase transparency and achieve the slated goals of the document:

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One, we have always suggested that the quality of independent directors is imperative. Forget SOX as a prerequisite. A well-managed company should never feel threatened by the number of independent directors challenging consensus in the boardroom. Good governance is being open to constructive criticism. If a company has lacked strategic direction for years, a fresh perspective from independent minds is invaluable. Our greatest criticism gleaned from the published data is the high concentration of the three A’s (attorneys, accountants and academics) as independent directors which is more acute the smaller the company. Diversity (of opinion) on boards is imperative but the figures suggest a group think mentality (Kintaro-ame) approach skewed to such a narrow field of professions limits innovation as no two companies are alike. How do authorities change it?

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Simply, secondly, and more importantly we think that companies need to introduce proper incentive structures for executives. Our studies show that companies tend to perform better when board members (insiders) have a higher proportion of their remuneration linked to stock performance. Stock incentives, especially in larger corporations, are often a minuscule part of total compensation for leaders. So much so that there is little incentive to focus on chasing real returns through more aggressive strategy. Fix this and independent director selection will be more serious.

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Third and finally, we think that the authorities should encourage corporates to adopt English language financial materials. A growing number are but the pace is slow. By doing so would invite more eyes from investors in markets where shareholder returns are prioritised. This would create an environment that would encourage Japanese corporates to unlock shareholder value. The JPX would accrue large upside. Not only would it gain more status as a proper global exchange, it would invite higher activity which would improve liquidity which is a virtuous circle for a financial exchange.

In short, Japan remains by and large a masterclass in risk avoidance. Until company executives have performance linked remuneration structures we believe independent directors will do little to help drive shareholder returns. Kintaro-ame independent director selection is not the way forward. By prioritising the linkage of remuneration, driven by higher disclosure via English language we think the ultimate aims of The Code can be achieved and the soft corporate governance approaches we have seen to date with the failures of Toshiba, Sharp and Olympus can be consigned to history.

2017 Full report