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Recent scandals are only the latest examples of the need for reform.

By Nicholas Benes Updated November 2, 2011

A recent wave of corporate scandals sweeping Japan has again highlighted poor governance standards there. For long-time Japan watchers, the sense of “déjà vu all over again” is truly disturbing. Why is it that Japan hasn’t been able to fix rules that have been broken for so long?

Consider the recent lapses. Most notably at Olympus, the chairman who resigned last week allegedly engineered deals in which the company, for reasons as yet unknown, grossly overpaid in a series of mysteriously connected M&A transactions, and then fired the foreign-born chief executive when he tried to bring accountability to bear.

Daio Paper is suing its former chairman for allegedly “borrowing” $140 million from subsidiaries without permission, which is a classic hand-in-the-cookie-jar scandal in a Japanese founder-family led company. The board was not even asked to approve the 26-odd loans that were made.

Tokyo Electric Power Co., or Tepco, which is in the midst of receiving a bailout after board oversight and risk management lapses contributed to a dangerous and costly disaster at the Fukushima Daiichi nuclear plant. Kyushu Electric is embroiled in a political influence scandal in which managers allegedly endangered the firm’s reputation by trying to trump up the appearance of support for the company’s desire to restart its nuclear power plants after a government-imposed shutdown.

The basic elements of these scandals are all too familiar: a toxic mix of lack of transparency, accountability, and independence on boards. Japan has been down this road many, many times before. Why has nothing changed?

The problem is that Japan has never seriously attempted a major overhaul of its corporate governance system for all listed companies. Structural gaps in the Company Law leave Japan Inc. without essential legal infrastructure and principles that are already in place elsewhere. This is exacerbated by a lack of training for board members and executives about how to enforce the existing standards that do exist.

Tokyo has spent the past 20 months considering changes to the Company Law “to improve governance.” However, the proposals so far drafted by the Ministry of Justice’s advisory committee fall far short of achieving this goal. What is missing?

First and foremost, the Company Law needs for the first time to include a definition and role of “independent outside director,” and do so in a way that will enable outside voices on boards to be effective. Currently there is no legal definition of “independent director.” There is only “outside director,” a term interpreted simply to mean anyone who has never worked for the company. That narrow concept doesn’t capture many people who might be too close to management to be truly independent.

Second, the Company Law needs to strengthen the role of independent directors by requiring a minimum number. It should also require committees of independent directors to take charge of clearly defined matters, such as self-dealing transactions, investigations or pricing of management buy-out deals, where the chance of management self-dealing is high.

Such fairly simple reforms could have averted some of the recent scandals, or at least hastened their exposure and accelerated the recovery of corporate credibility so as to cut down on damaging uncertainty for investors.

At Olympus, under the current law there was no legal mechanism for the board to handle the allegations of impropriety that former chief executive Michael Woodford raised when he first disclosed the chairman’s suspect dealings. Under corporate law in most places, independent directors already sitting on the board would have immediately formed a special committee that was legally authorized to investigate. It would have been harder for the chairman’s personal irritation to push Mr. Woodford out of the company.

Instead, the company thrashed around for three weeks forming a “third-party committee” comprising persons, however reputable, with no legal duties, liabilities or investigation rights. This is because they are not board members.

When executives know that they can be immediately investigated and fired by neutral outsider committees for gross incompetence, malfeasance and lack of transparency, slack company habits no longer pass muster and fewer scandals occur. If this sort of protection had existed in Japanese law already, it is unlikely that some of the recent problems would have occurred at all, or in the value-destroying way they did.

In part, this would be due to the diligence and ethics of Japanese employees. Internal whistleblowers at Olympus and Daio (and possibly, Tepco) would have probably given information to committees of independent directors earlier, and these committees, which would have had teeth, could have acted earlier. Similarly, Kyushu Electric would not have been able to excise the portions of the report by its “third-party committee” that it found inconvenient.

Improving governance will not simply be a matter of changing the law, however. Japan Inc, and Japan more broadly, needs an update in thinking on governance issues.

Part of the problem is political. Although the current Democratic Party of Japan government is less business-friendly than the long-ruling Liberal Democratic Party before it, policy makers and the media still buy into a reflexive attitude that what’s good for Japanese executives is good for their companies, and what’s good for companies is good for Japan. Policy makers need to be much less deferential to corporations on governance issues. In this respect, the DPJ needs to push the Justice Ministry to move forward with meaningful governance reforms despite industry reluctance.

In tandem with that, citizens need to understand that governance failures are not a matter of one bad company here and there, but rather arise from structural and systemic weaknesses. Domestic investors in particular should demand better governance instead of assuming that “what Japanese managers want is probably right.”

Investors have lost $46 billion on Olympus, Daio, Kyushu Electric and Tepco combined this year, not to mention other scandals over the years. Bad corporate governance is a costly mistake Japan can ill afford, and a growing embarrassment for a country that deserves far better.

Mr. Benes is representative director of the Board Director Training Institute of Japan, a non-profit public interest organization.