The failure of the department store operator Sogo Co. is a typical case of corporate governance gone awry. It has exposed some of the old problems in Japanese-style management, relations between main creditor banks and corporate clients, and bank regulation by the Finance Ministry. The incident offers valuable lessons concerning the future of the Japanese economic system.

Sogo collapsed under a crushing debt burden — a legacy of the reckless expansion policy pursued by its charismatic leader Hiroo Mizushima. About half of the 20-odd deluxe stores the group opened across the country during his reign were in the red. The Commercial Law provides for an internal system of corporate governance whereby directors and auditors are appointed to monitor or restrain corporate management. In Sogo’s case, this system did not work as it was supposed to.

The Industrial Bank of Japan, Sogo’s main creditor bank, jacked up lending to the retailer with the help of Mizushima, a former IBJ officer. Mizushima himself said recently that IBJ had forced Sogo to take out unwanted loans. The unspoken message is that the main bank is partly responsible for the debt debacle. But IBJ President Masao Nishimura, speaking at a Diet hearing, denied any lender responsibility.

It appears that the corporate governance system stipulated by the Commercial Law did not work for the IBJ, either. The loss of discipline in management is evident in its runaway lending to the debt-ridden department store chain.

Main creditor banks are supposed to monitor their clients. The IBJ, however, turned a blind eye to Sogo’s excesses for many years. In Diet testimony, Nishimura said IBJ found out in 1994 that Sogo’s liabilities exceeded assets, and sent in a vice president to stop Mizushima — but to no avail. The market was kept in the dark about Sogo’s true financial standing until earlier this year.

The Finance Ministry did a poor job as the regulatory agency, allowing banks to go on a lending binge. This happened because there was a cozy relationship between the ministry and the banking community. The ministry protected the banking industry, and in return banks offered cushy jobs to retired ministry bureaucrats.

For example, the Finance Ministry allowed banks to earn huge commissions on corporate-bond flotations. The so-called commissioned-bank system was maintained for at least a decade after it was found to be a major cause of the “hollowing out” of the Tokyo capital market.

Banks also benefited handsomely from the so-called bond registration system, which allowed them to take custody of corporate bonds for fees. This system, which still exists, is another case of public regulators defending sectoral interests instead of the national interest. No wonder the Finance Ministry failed in its supervisory role.

Sogo’s saga marks the end of a myth — the notion that a pyramid-like oversight system with the Finance Ministry at the top effectively guaranteed the stability of the Japanese economic system. According to this theory, the ministry supervised banks, and banks supervised corporate clients.

That was indeed a myth — an illusion, to be more exact. During the high-growth period, banks and clients piled up profits. Bankruptcies, except for those involving marginal businesses, were few and far between. I think corporate Japan was simply lucky.

After the economy hit the skids, the flip side of the myth exposed itself with a vengeance. I am not just talking about Sogo and IBJ. Many Japanese companies, including banks, made similar mistakes. The Finance Ministry fell into disgrace, and corporate balance sheets deteriorated rapidly.

The basic lesson is this: Japanese banks and businesses must lift themselves by their bootstraps and start building a credible system of corporate governance; otherwise they won’t be able to ride out the storm of market-driven globalization.

The fundamental problem in Japanese-style management was that Japanese companies did not live up to the spirit of corporate governance, although outwardly, they managed themselves in accordance with the Commercial Law.

The reason for that has to do with Japan’s social and cultural traditions. In the eyes of both employers and employees, the company was a “closed community” that guaranteed their lifetime livelihoods. They were united by a strong sense of camaraderie and allegiance, like the feudal clans of the Edo period.

The annual shareholders’ meeting was a rubber stamp that endorsed the president’s choice of cronies for executive posts. These and other agenda items were processed pro forma because major shareholders, such as creditor banks and corporate clients, gave the directors carte blanche.

In a “closed” organization, retired old-timers often became auditors on the president’s coattails. Given such corporate cronyism, it was difficult for inside auditors to do what they were supposed to under the Commercial Law: Monitor or restrain the president and other representative directors.

Recently, however, Japanese companies began searching their souls, and grew determined to live up to the spirit of the Commercial Law. They are now keenly aware that the lack of internal discipline caused many mistakes in judgment. Some are seeking to make better use of outside directors and auditors. Others are trying to draw the line between management and operation with directors overseeing operating officers.

The market is the most powerful incentive for better corporate governance. The major corporate collapses of recent years show that companies cannot survive if they lose market confidence. Corporate survival rides on good governance and good disclosure. No wonder Japanese companies are trying to listen very carefully to what the market has to say.

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