The special committee formed to investigate recent events at Olympus Corp. has issued its report on what has turned into Japan's biggest corporate scandal in years, one which has brought the 92-year-old company to the brink of delisting. What lessons can investors draw from the scandal?

The scandal itself began with an attempt to hide over JPY 100 billion in investment losses by moving bad assets off the balance sheet, in anticipation of the introduction of mark-to-market accounting. Many Japanese companies engaged in similar behavior in the wake of the collapse of the economic bubble in the early 1990s, but Olympus continued the deception far longer than most (although the revelations about Olympus have caused some to wonder if other companies may still be engaged in such behavior). Inflated payments in connection with acquisitions as recently as 2008 were used to cover investment losses dating back to the 1990s. Although the special committee found no evidence that "anti-social forces" (i.e., organized crime) played any role in helping Olympus perpetrate the fraud, the fact that so many observers suspect such involvement is a problem for the credibility of corporate Japan.

Olympus first made headlines in October when it abruptly fired its recently-appointed CEO, Michael Woodford. The company's initial explanation for the firing--that Woodford had violated protocol and failed to understand Japanese management--would have seemed plausible to many Japanese observers keenly attuned to the differences between Japanese companies and their Anglo-Saxon counterparts. Yet Woodford had seemingly thrived at Olympus for many years, and had apparently impressed the board enough that he had been chosen as CEO over his Japanese colleagues.

Once Woodford began to go public--admittedly a very un-Japanese thing to do--with the news of Olympus' questionable M&A transactions, it emerged that his real sin had been to challenge the rest of the management team, led by his predecessor Tsuyoshi Kikukawa, over those dubious transactions. This raised questions as to whether Woodford had been chosen as CEO with the expectation that he would never uncover the accounting fraud, and would allow Kikukawa to continue to wield influence as executive chairman--or with the expectation that he would be the one to take the fall in the event the scandal came to light. While it would be unfair to suggest that shareholders should generally be skeptical of a company's motivations for hiring a foreign CEO, in a consensus-driven and hierarchical corporate culture such as Japan's, the hiring of a surprise candidate (whether foreign or native) may be a sign that none of the obvious candidates wanted to take the job.

The practice of a "retired" CEO continuing to exercise power from behind the scenes (as executive chairman, or as a consultant or advisor) is a well-established phenomenon with many antecedents in Japanese history, from emperors in the feudal era to politicians like former Prime Minister Kakuei Tanaka. Shareholders may justifiably be concerned with the potential for these former CEOs to undermine their successors' authority. Yet there are limits on what shareholders can do about it: even if such individuals are voted off the board, they may be appointed to advisory posts where they may continue to wield influence without the accountability that comes from a board seat.

The obvious way to balance the power of current and former executives is to appoint outsiders to the board. Yet when Japanese issuers complain that there is a shortage of qualified candidates, it is not entirely an excuse. Japanese executives tend to have spent their entire careers with a single company or group, and many lack some of the transferable skills that executives elsewhere may have gained through a diverse career or through formal study of corporate finance, law or management; making them less well-suited to serve as outside directors of other companies. The insularity of Japanese management teams also means that when an outsider, or even a foreign-born executive like Woodford, does join the board, he or she can have a major disruptive impact.

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