In response to the revelation that Olympus Corp. had concealed huge losses on financial assets for many years, the Tokyo Stock Exchange on Jan. 20 designated its stock a "security on alert," allowing the company to retain its listing.
Although the decision itself is not unjustified, the TSE’s disciplinary system should be improved in certain respects.
The TSE's regulations stipulate that if a company's securities report or other disclosure filing contains any misrepresentations deemed to be material by the TSE, the company's stock shall be delisted.
In the Olympus case, however, the TSE decided that this provision had not been violated.
The security-on-alert designation was first adopted in November 2007. It is applied to companies that committed violations deemed to possibly be grounds for delisting but ultimately determined not to be.
Designees urgently need to improve their internal controls. They are granted three years to do so, during which time they must annually submit affirmations regarding the state of their internal controls to the TSE.
Designees that fail to adequately improve their internal controls within three years are delisted.
Excluding Olympus, there have been 10 security-on-alert designees to date.
Three of them succeeded in having the designation rescinded by improving their internal controls. Five others were ultimately delisted due to bankruptcy, mergers or other reasons.
The designation can be thus characterized as a means of inducing companies to improve their internal controls when they have made "gray area" misrepresentations not material enough to warrant immediate delisting.
Olympus' loss concealment attracted much public attention in Japan, partly because the company is renowned as a top global manufacturer of endoscopes and other optical medical devices.
Another factor behind the public interest is that Olympus had appointed a Briton, Michael Woodford, as its president, making it a rarity among listed Japanese companies.
The scandal came to light when Woodford was abruptly dismissed six months into his tenure for attempting to investigate the concealed losses.
Some have criticized the TSE's decision on security-on-alert designation on the grounds that Olympus rightfully should have been delisted given the facts in the case.
A number of companies have previously been delisted for making material misrepresentations, including Seibu Railway, Kanebo and Livedoor.
Other companies, including IHI and Nikko Cordial Group, have remained listed despite making misrepresentations involving large sums of money.
Among these cases, the circumstances of Seibu Railway and Kanebo were such that even if they had not made misrepresentations, they most likely would have been delisted anyway.
Additionally, Livedoor had split its stock several times, including a 100-to-1 split, in addition to falsely reporting operating losses as profits. The news of its accounting fraud triggered a huge spike in trading volume that could have crashed the TSE's trading system.
In contrast to these cases, Olympus' loss concealment was arguably not a material misrepresentation given that there was no long-term deception regarding its profit level or earnings trend, although it was egregious in certain respects, including its long duration and top management's heavy involvement.
From such a standpoint, the TSE's decision is by no means unreasonable. However, the TSE's use of materiality of misrepresentation as a delisting criterion has been persistently criticized as an opaque standard.
Although the TSE has clarified its decision-making criteria to a considerable extent through its many decisions in disciplinary cases, it may need to take further steps to enhance the perceived fairness of its decisions, such as establishing an appeal process for delisting decisions.
Strengthening the punitive aspects of security-on-alert designation is also worth considering.
In the case of stocks listed on the TSE’s First Section, one idea is to disqualify security-on-alert designees from inclusion in the TOPIX index.
Olympus was fined 10 million yen ($120,000) for violating its listing agreement. Instead of a flat 10-million-yen fine, the TSE should consider imposing fines that vary in size based on the severity of the violation.
Incidentally, in the Olympus case, some non-Japanese institutional investors argued against delisting on the grounds that delisting due to misrepresentation is contrary to global standards.
While delisting is undeniably disadvantageous to existing shareholders, delisting of problem companies is intended to protect prospective investors.
The delisting criteria of overseas stock exchanges grant the exchanges broad discretion, including even the power to delist on the grounds of misrepresentation.
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Sadakazu Osaki is head of research at Nomura Securities Co.’s Center for Strategic Management and Innovation.
This report was published in lakyara, an English-language publication of the institute, and was edited by The Asahi Shimbun.
The original report is available at (http://www.nri.co.jp/english/opinion/lakyara/2012/pdf/lkr2012134.pdf).
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