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Carlos Ghosn was widely recognized as a hero in Japan for turning around Nissan when it was on the brink of bankruptcy in 1999. Things couldn’t look more different today. Ghosn was recently arrested for financial misconduct, fired from his position as Nissan’s board chairman, and criticized by Nissan’s Japanese CEO for accumulating too much power. Without Ghosn, the Nissan-Renault alliance is likely to falter — leaving two small auto manufacturers without competitive economies of scale.
Ghosn’s swift downfall comes as a result of a Japanese criminal case against him for causing Nissan to make incomplete securities disclosures about his deferred compensation. These disclosure problems are rooted in the company’s weak governance procedures, and they offer a lesson to investors in Japan’s other listed companies about the need for much stronger governance protections than those brought about by recent Japanese reforms.
The heart of the legal controversy is whether Nissan violated Japan’s securities laws by not including Ghosn’s deferred compensation in its annual reports over the last eight years. Under Ghosn’s deferred compensation arrangement, he would receive substantial payments from Nissan after his retirement – the equivalent of $44 million. Such payments were not taxable when this arrangement was made, but would become taxable when Ghosn actually received them.
Since 2009, all Japanese listed companies have been required to disclose in their annual reports an executive’s compensation if it exceeded 100 million yen – the equivalent of $800,000. This rule was pushed through by the new head of Japan’s Financial Services Agency, an outspoken critic of the high pay awarded to corporate executives.
According to this Agency, executive compensation includes retirement bonuses, which must be disclosed once they are fixed in amount. But a lawyer for Greg Kelly, a former Nissan executive who consulted outside experts about Ghosn’s deferred compensation arrangements, said that his client believed that the payments due to Ghosn were not “fixed” in amount and therefore were not disclosable.
Nevertheless, an article in the Nikkei Asian Review stated that Japanese prosecutors had obtained internal Nissan documents allegedly showing that the amounts of the deferred payments to Ghosn were fixed and therefore subject to disclosure. If these documents in fact exist, they raise fundamental questions about the company’s role in any securities violation and the failure of its governance procedures.
These questions should be of concern to all investors in Japanese listed companies, as many Japanese public companies have explored strategies for reducing the amount of CEO pay included in their annual reports. As one accountant based in Japan during 2010, explained, “there was a big rush of inquiries about schemes that might be used either to split out salaries or defer part of it.”
If Nissan’s internal documents show that Ghosn’s deferred compensation was “fixed” in amount, why didn’t the Chief Financial Officer include these payments in its annual reports for eight years? Didn’t Nissan have internal controls designed to assure the accuracy and completeness of its public disclosures? And didn’t Nissan’s independent auditors check the disclosures in its annual report against the compensation records for its highest paid executive?
Let’s start with the last question. The independent auditor of Nissan was the Japanese affiliate of Ernst &Young, which served as the external auditor of two Japanese companies recently involved in major accounting fraud – Olympus and Toshiba. Nissan does not have an audit committee, which would be required to appoint its independent auditor and reviews its audit procedures under the laws of most advanced industrial countries. Instead, the independent auditor is effectively chosen by the company’s chairman, subject to board approval. As a result, when making close calls on the company’s financial reports, that auditor may be too deferential to Nissan management.
Another problem is Nissan’s board does not have a compensation committee, which would decide the pay of the company’s top executives under the laws of most advanced industrial countries. Nor does the board issue a compensation report, which explains the rationale and metrics for setting executive compensation. Although Ghosn claimed that the board is “sovereign” on setting his pay, Ghosn had enormous leeway in determining the amount and structure of his compensation. His discretion undermined the connection between company performance and CEO pay that investors want to see.
The Nissan board also has no nominating committee; its chairman chooses the independent directors, subject to the board’s approval. By contrast, the laws of most advanced industrial countries require the board to be composed of a majority of independent directors, who are interviewed and recommended by its nominating committee. The purpose of a nominating committee is to assure that directors are selected on the basis of competence and independence, rather than friendliness to management.
Since 2002, listed Japanese companies were permitted to have three board committees— audit, compensation and nominating. However, my analysis of 3,803 such companies shows that only 22% had an audit committee and less than 1% had all three committees.
In 2015, Japan reformed its corporate governance code to require boards to have at least two independent directors. Nissan was among 11 companies in Japan’s TOPIX 500 to resist this reform. In 2015, Nissan had one outside director, but he was a former Renault executive and not really independent because of the Nissan-Renault alliance. Only in April 2018 did Nissan add two new independent directors, though they both lacked business or management experience — one was a race car driver; the other was a former Japanese bureaucrat — the Chief of the International Trade Policy Bureau.
After the Ghosn investigation began, Nissan did approve the creation of an advisory committee, composed entirely of independent directors. Although such committees have become popular in Japan under its new governance code, they have no real power to make corporate decisions, such as changing Nissan’s board structure.
A final problem for Japanese corporate governance is the extensive cross holdings of shares between companies with close business relationships, such as distributors or suppliers. These cross holdings make it very difficult for unaffiliated shareholders to hold management accountable for sitting on unproductive piles of cash or subpar financial performance through a proxy contest or takeover bid.
While Ghosn was a vocal critic of Japanese cross holdings, the Nissan-Renault alliance remains a notable example of this practice. Renault holds a 43% voting position in Nissan; in turn, Nissan holds a 15% non-voting position in Renault. Since Renault has de facto control of Nissan, public shareholders had no effective way to curb misbehavior by Ghosn or other Nissan executives.
The ratio of cross holdings to total shares at Japanese companies (excluding shares held by insurers) has fallen on average from 35% in 1990 to 10% in 2016, according to Nikko Asset Management. On the other hand, the Japanese Pension Association says that at least one third of the shares of Japanese listed companies are held by “allegiant” investors — including insurers and banks as well as corporate parents, founders’ families, and other affiliated firms — who almost always vote with company management.
In June of 2018, the Tokyo Stock Exchange introduced a revised version of the Corporate Governance Code, which strongly encourages Japanese listed companies to reduce their cross holdings. If that happens, it would give shareholders a better chance of holding management accountable for serious executive misconduct or poor company performance.
Whatever the outcome of the criminal investigation of Ghosn, it demonstrates the need for different committee structures at Japanese listed companies. The board of these companies should have a majority of truly independent and qualified directors, who should constitute a majority of its nominating, audit, and compensation committees. The nominating committee should find and recommend new directors; the audit committee should appoint the external auditor and review the company’s internal controls; and the compensation committee should set the criteria for executive pay in advance and explain the results to shareholders. If Nissan’s governance procedures had followed these recommendations, it likely could have avoided the recent scandal.
In short, Japan has taken some significant steps to improving the governance procedures of its listed companies. But most of these companies still have a way to go to reach the best global practices of corporate governance.