Published in the Nikkei Asian Review 27/1/2017
Corporate scandals occur in many places and in many shapes and forms. Usually the misdeeds are particular to the company concerned, but sometimes they tell a bigger story, one of time-honoured corporate cultures struggling to cope with new economic and social realities. Such is the case with the recent troubles of two iconic Asian companies, Toshiba and Samsung Electronics.
The case of Toshiba is Japan’s first, though probably not last, example of an American-style, bull market corporate scandal. In previous decades, investors had become inured to backward-looking corporate cover-ups, such as the Olympus scandal of 2011.
That was brought to light when British CEO Michael Woodward blew the whistle on his own company, which had been concealing huge investment losses since the early 1990s. In bear market scandals of this sort nobody gets rich and the disclosure corrects no great injustice.
In contrast, the Toshiba scandal was forward-looking and had obvious beneficiaries. In line with corporate Japan’s new emphasis on RoE (return on equity), top management set ambitious internal profit targets for the main divisions. The word went out that they were to be achieved by all means possible. The targets were met soon enough – but through channel-stuffing, backloading of costs on projects, unrealistic valuation of acquisitions and other accounting flim-flam.
When the deception was exposed in 2015 and the ugly truth laid bare, the result was a torrent of red ink. A scheme intended to boost shareholder value and reflect glory on top executives ended up sinking the stock price to 35 year lows and imperilling the company’s stock exchange listing.
As fiddles go, it was hardly in the Enron class, but given the company’s illustrious tradition the shock-waves were palpable.
KARAKURI DOLLS AND SUTRAS
The two companies that came together to form Toshiba were founded by two remarkable inventors.
Hisashige Tanaka, born in 1799, was a self-taught genius who created long-burning lamps served by fuel pumps, clocks that ran for a year and karakuri mechanical dolls that could walk, shoot arrows accurately and pick up ink-brushes and write Chinese characters.
Ichisuke Fujioka visited Thomas Edison in the United States and pledged to the great man that he would build an electric power industry in Japan. And he did just that.
Restoration of one of Tanaka’s “karakuri” dolls
The company’s austere integrity was symbolized by ex-engineer Toshio Doko who became CEO of Toshiba in the 1960s and an advisor to prime ministers in the 1980s. Doko, a devotee of Nichiren Buddhism, lived in a small wooden house and woke every morning at 4 a.m. to chant sutras. He used the same hairbrush for 50 years and went to work by bus even when head of the Keidanren association of large corporations. He once said “I don’t trust people who live in luxury residences.”
Toshiba grew into a sprawling industrial empire, with a vast portfolio of products ranging from rice-cookers to guided missiles, from light-bulbs to locomotives. Amongst its many innovations are the world’s first laptop computer (1985), flash memory (1991) and DVD player (1997).
For much of its history Toshiba epitomized the technological prowess and dynamism of Japanese conglomerates. By the 1980s its logo and advertising slogans had become familiar sights in Western capitals. From the 1990s onwards, though, the going grew a lot tougher. Lower cost competitors, one of which was Samsung, proved as adept at copying Japanese products as the Japanese had once been at copying American and European products.
Doko had counselled Japanese companies to exit businesses that other Asian countries were entering and move up the value chain, but Toshiba and its Japanese peers ploughed yet more capital into TVs, memory chips and other commoditized products. The result was chronic financial deterioration. Even the fake profit margins the company was posting before the deceit was uncovered were measly by international blue chip standards.
Doko-san enjoying his favourite meal of anchovies, rice and soup
THE REPUBLIC OF SAMSUNG
Samsung Electronics, like most of Korean industry, went through a savage restructuring during the Asian crisis of the mid-1990s. It emerged in ferociously competitive shape, with the structurally weak won adding a welcome boost.
The company’s strategic focus on three key products – LCD panels, flash memories and smart phones – proved to be a masterstroke, giving it a powerful position in rapidly growing markets. Profits have boomed as an army of talented engineers and designers have kept it ahead of the ever-changing technology game.
Investors are certainly not complaining. The stock has risen 580% this century and accounts for about 20% of South Korea’s total market capitalization. Even after the recent scandal, Samsung Electronics’ stock is up 60% over the past 12 months.
The involvement of Jay Y. Lee, vice-president of Samsung Electronics and de facto leader of the Samsung group, in the scandal surrounding President Park Geung-hye is complicated and murky, but the eruption of street protests involving ordinary middle-class citizens speaks of deep dissatisfaction with the status quo.
Clearly, there is little problem with the operational side of the company – the excellence of its track record speaks for itself. Rather the issue is governance. Specifically, the merger of two Samsung group companies in 2015 was waved through at terms that benefitted the founding family at the expense of minority shareholders. There are suspicions of dodgy dealings at the highest levels.
Not for nothing is South Korea sometimes dubbed “The Republic of Samsung.”
Protests in Seoul
THE GOVERNANCE VACUUM
In pre-war Japan, the commanding heights of industry were dominated by the zaibatsu, groups of related companies controlled by a founding family. After Japan’s defeat the American occupation authorities broke them up on the grounds that they had been complicit in militarism.
In the 1950s and the 1960s the companies came together again in looser groupings called keiretsu, this time with no wealthy capitalists on the shareholders’ register. Instead there developed a pattern of cross-holdings which bound the keiretsu members together and served as bulwarks against interfering outsiders. Toshiba joined the Mitsui zaibatsu in 1893 and remains part of the Mitsui keiretsu today.
The upside of this arrangement was that in the high-growth era Japanese companies could support each other and managements were free to invest as they liked, with ample capital available from the group’s main bank. The downside, increasingly apparent from the 1980s onward, was the existence of a governance vacuum. Japanese managements had little incentive to take the bold decisions necessary in rapidly changing circumstances and there was nobody to pressure them.
Korea, not being a defeated nation, underwent no such enforced restructuring. Wealthy families continue to control the industrial groups known as chaebol, which is written with the same Chinese characters as zaibatsu.
The upside is that the companies are run by people with a vast amount of skin in the game, like the Lee family, as opposed to the cautious “salaryman CEOs” who are still numerous in Japan. The downside is the age-old political question: Quis custodiet ipsos custodes or “Who guards the guardians?” In the absence of transparency and shareholder democracy, what is to stop the oligarchs from abusing the rights of minority shareholders, practicing nepotism or damaging civil society by corrupting politics?
The absence of good governance is rarely an issue when everything is going well. But in the dynamic world of technology, winners don’t stay winners forever. Not just Toshiba, but Nokia, Motorola, Xerox, Fujitsu and many other faded stars can attest to that.
With Chinese challengers becoming ever more sophisticated in smart phones and other devices, even the mighty Samsung Electronics may face testing times ahead. The recall of exploding Galaxy 7 smart phones is financially trivial, but also a reminder not to take anything for granted.
SETBACKS SPUR CHANGE
The Toshiba scandal has already had a positive effect on the company itself and on corporate Japan as a whole. It has shown that increases in RoE must come from structural improvements, not accounting legerdemain. For over-extended behemoths like Toshiba, concentrating resources on strong businesses and exiting the weak ones is essential. In 2016 the company sold its household goods business to China’s Midea and its medical instruments business to Canon. It has the depth of technology to survive, but in order to prosper it will have to make further efforts to reinvent itself.
The Samsung scandal may well be constructive too. The Korean stock market trades on the lowest price earnings ratio in the Asia Pacific region partly because of the discount applied by investors to compensate for shabby treatment of outside shareholders. If the political reaction leads to a weakening of the hold of chaebol oligarchs, there will be benefits for investors and the wider South Korean economy, as more space appears for entrepreneurial activity.
In the words of the great Toshio Doko, speaking 40 years ago, at a time when economic conditions were much worse than now, “just as we needed a lost war to change from militarism to democracy, so people always need a spur to do something new.”
Books by and about Toshio Doko