Asymmetrical Information

Citibank/Citicorp is a company weak in integrity from top to bottom. Its subsidiaries were the worst-implicated in the recent investigations that led to forced separation of analyst and investment-banking arms of financial services companies. Its Primerica branch operates a sordid pyramid scheme exploiting middle-income investors. Its former chairman, Sanford Weill, indulged in bribery-type actions in connection with the Jack Grubman / AT&T scandal, and was justifiably forced to refuse nomination to the NYSE board. If Japanese regulators have found substantial problems with the company's conduct, that does not surprise me.

I don't want to defend Citigroup, but I'm not convinced that Japanese action is determined only by the details of the case. Japanese regulators have only shut down one Japanese bank, and that bank "coincidentally" was the most active in getting funds to North Korea (not directly to the government - from Koreans living in Japan to their relatives; still, it helps to support North Korea). Regulators didn't mention this as one of their reasons, but....

So, did they decide that this is a good time to limit the activities of U.S. banks in Japan?

They shut down a unit of Credit Suisse in 1999:

The only other bank to face shutdown orders from Japanese regulators was Credit Suisse Financial Products, which had its banking license revoked in 1999 for blocking an investigation into whether it was engineering financial products specifically to help companies conceal losses on their accounting statements. The company was a unit of the Credit Suisse Group.

After all, foreign companies don't understand the 'uniqueness of Japanese snow', as a government official put it while protecting the Japanese market from foreign skis.

But the big question is, are Japanese offenders "dealt with quietly", or are they not dealt with at all?

Mindles,

I feel I have to clarify on the current state of the Japanese equity market. Although your description was accurate a few years ago there have been dramatic changes in the Japanese market in the last couple years. Between 1997 and 1999 the Business Accounting Deliberation Council issued several new accounting standards which brought the level of disclosure for Japanese companies dramatically in line with Western standards, such as the consolidation of financial statements and fair value accounting. These changes have had a significant effect on how Japanese companies operate since they went into effect in 2000. A large number of Japanese companies have unwound there cross-shareholdings (were companies purchase each other’s stock), which limited the ability of shareholders to challenge management. Japanese companies are increasingly focusing on financial performance with specific ROE targets – although this is still not true across the board – resulting in a cleaning up of the balance sheet and the closing (or selling) of non-performing subsidiaries. As a Japanese equity analyst I have probably met with the managements of over 50 Japanese companies in the last two years. My experience is about 60-70% have specific financial goals with a clear, articulated strategy as to how they will achieve said goal. Additionally, as of 2003 Japanese companies can elect and are electing to have a US-style board structure with independent non-executive directors. I think the fact that an executive from the US private equity firm Ripplewood has a seat on the board of Shinsei Bank and the recent brouhaha surrounding the potential UFJ merger says a lot as to how dramatic the changes in corporate Japan have been.

As an example of the level of financial disclosure in Japan these days, if you’re so inclined, take a look at UFJ’s annual report (in English):

http://www.ufj.co.jp/english/investor_relations/annual_report/latest_ar/ar2003/ar2003.html

(1.35mb, pdf)

Brian thanks for that. I suspect my knowledge is indeed dated, as my Japan days are well behind me. Do you really feel they are 'in line' with U.S. levels of disclosure? - they have travelled the whole distance? (not that the U.S. is necessarily an ideal)

I think that the Japanese are in many respects in-line with the US at this point, at least with the companies that most US institutional investors are interested in. The level of foreign shareholders in specific higher profile Japanese companies has risen significantly in the last year or so which has put a great deal of pressure on management to clean things up. From my experience I have found that dealing with Japanese management can sometimes be better in terms of disclosure when you are in a face-to-face meeting than with US management. In part I think it is because they don't understand what US investors are looking for to the extent that the management of US companies do. Therefore they don't necessarily have “the correct” answers at the ready. The other aspect is (as long as they don't have an ADR in the US) they are not limited by Reg FD which puts limitations on what the management of US companies can disclose to institutional investors in private if they haven't made the information public beforehand. But in general the cozy relationship between business and government is evaporating, which improves the environment for enforcement.

Currently the International Accounting Standards Board is working to converge the accounting standards of markets globally. For the most part the IAS framework is broadly in-line with US GAAP (Generally Accepted Accounting Practice) with the exception of a few things (like I believe the treatment of goodwill). Many countries, specifically those in the EU, are supposed to adopt the IAS in 2005. I imagine Japan given time will get there as well at some point.

In terms of how good a regulatory environment is in one country vs. another I think it’s necessary to keep in mind that there are two aspects of it that need to operate well in order to protect shareholders. One is the level of disclosure required and the other is enforcement. The US has been and still is the best system in terms of the required level of disclosure. It is the other aspect, enforcement, where the US had been weak. However I think that is changing. Although the Sarbane-Oxley Act has been criticized as doing too little or being too confusing there are aspects of it, besides the requirement that the CEO certify the reported financial results, which haven't gotten much media attention that I think have significantly changed the level and nature of enforcement for the better. Obviously, regardless of how good an accounting system is it will always have limitations. If an executive knowingly wants to break the law and hide certain transactions he or she will be able to do it, at least for a period of time. But there are also two structural aspects of the US market that had added to the problem. One was the issue of the conflict of interest on the part of accounting firms that both audited the financial statements of a company and sought lucrative consulting jobs. This has been largely solved. The other structural problem which seems to be improving but still has a long way to go is the shareholder apathy (including institutional shareholders) towards voting against management recommendations. If shareholders were more focused in getting independent board members elected rather than the friends of the CEO and challenging management pay packages then there would be a lot less corporate governance issues in the US. I think it is rather ridiculous that we blame the system or accounting firms for things that could have largely been avoided if shareholders just took more interest in the general shareholders meeting.

If shareholders were more focused in getting independent board members elected rather than the friends of the CEO and challenging management pay packages then there would be a lot less corporate governance issues in the US. I think it is rather ridiculous that we blame the system or accounting firms for things that could have largely been avoided if shareholders just took more interest in the general shareholders meeting.
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Could you elaborate on this? My impression is that boards, for whatever reason, are generally not bound to obey shareholder votes, so that, e.g., proposals to limit executive pay or expense stock options, etc. routinely garner majority shareholder votes and are not implemented. It is remarkable in fact that such votes pass given large numbers of shares are held indirectly through mutual funds, etc., limiting shareholder access. I don't think the brokerages and financial services companies that hold these shares directly have sufficiently strong compelling interest in maximizing shareholder value. Finally, the system is such that large direct shareholders (retirement funds, etc.) tend to have holdings in multiple companies, often too many for them to concentrate resources on, say, researching appropriate candidates to nominate for director positions who are likely to be accepted in each company they hold a stake in.

Buy and large you are right that there are limitations to what shareholders can do and I made too strong of a statement in saying that if investors got more involved with corporate governance issues a lot of these problems wouldn’t have occurred. It was more born out of frustration that people generally don't get involved with or worry about such issues until something goes wrong. It still amazes me that many analysts don't even read the annual reports of the companies they invest in let alone individual investors. As far as I'm concerned as an investor that is the least you should do.

Three points. 1) Only 0.5% of a mutual fund’s overall expenses are directed towards corporate governance issues. I can’t give you a comparative figure but my insider view is that travel expenses alone add up more than 0.5% because generally you do it a lot and it means flying business class, staying at 5-star hotels and eating at top 10 restaurants (I don’t buy the way. I fly coach, stay at cheaper hotels and eat at moderately priced restaurants). Although the mutual fund industry does not have to disclose manager's salaries and bonuses I can tell you that they are large - anywhere from a few hundred thousand to 8 figures. So I don’t think it's a lack of resources. 2) Historically institutional investors have not taken advantage of the power they do have to influence corporate governance issues nor have they used political pressure to change the laws that limit shareholder influence. If two or more large institutional investors worked together to put pressure on a board either through formal channels or informally behind closed doors they could have a great deal of influence. Large funds often have sizable positions to the extent that they may own close to 5% of the outstanding shares. The threat of withdrawing from or reducing such a position can carry a lot of weight with a board. I wish I had insight as to why this doesn’t happen but unfortunately I don't, except that there is a very weak argument about the potential to get sued by other shareholders. 3) Larger institutional investors have multiple analysts that only cover specific sectors and of those sectors may only have a few companies that the fund actually invests in. It would not necessarily take that much more work for each analyst to stay on top of corporate governance issues. Granted they may not have time to find alternative board members but they could more generally insist on a larger number of independent directors or that executive pay be more linked to long-term performance.

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