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In a recent major shareholder suit, the Osaka District Court ordered 11 former Daiwa Bank executives to pay a total of $775 million (about 83 billion yen) in compensation for the $1.1-billion loss the bank suffered from illegal bond trading by a former employee of its New York branch. The ruling has shocked Japanese corporate executives for more reasons than one.

First, they believe that it is unfair to impose unlimited liability on directors. Second, they feel the penalty is too severe given that Japanese executives are paid much less than U.S. executives. And third, some fear that incentives for people to become directors may be lost if such huge compensation is demanded.

Many members of the ruling Liberal Democratic Party are sympathetic toward the former bank executives. The Justice Ministry is reportedly considering plans to revise the Commercial Law, which would include a cap on executive liability and restricting the shareholder’s right to file a suit.

However, in view of the loose management practices in banks and real estate firms that have come to light since the bubble economy collapsed, the shareholder-litigation system should be used as a catalyst for corporate reform in Japan. The system should not be tampered with.

Japanese corporations are built on a structure of cross-shareholding and mutual confidence established and maintained through networks of long-term shareholders and keiretsu groups. This is part of the reason why U.S.-style hostile takeovers have not succeeded in Japan. In the absence of major shareholders who are critical, shareholders meetings serve as a rubber stamp for boards of directors, and fail to play their primary role of overseeing management.

Main creditor banks, which went on a lending spree during the bubble period to expand market share, have also failed to play their supervisory role. The Industrial Bank of Japan, for instance, was unable to stop management excesses in the department store operator Sogo Co., even though the bank had a seat on the retailer’s board of directors. Sogo collapsed in July and filed for court protection from creditors.

The biggest problem is that boards of directors lack self-discipline. Since directors are usually selected by the president from company lifetime-employees (cronies may be a better word), the board is hierarchically oriented, which tends to stifle critical discussion, particularly among lower-ranking directors.

Auditors are also handpicked by the president from retired old-timers with financial knowhow, such as former treasurers. No wonder they do not dare speak out against the boss. Certified public accountants often favor their corporate clients. Many unions also have cozy ties to management, as did Sogo’s union.

Thus, under the nation’s corporate system there are no effective mechanisms to check management. In these circumstances, shareholder litigation may be the only way of punishing or preventing management wrongdoings.

Shareholder suits have picked up momentum since 1998 when the prescribed legal fee was reduced to 8,200 yen across the board. The step was taken at the request of the United States during bilateral talks on economic structural issues. Currently about 300 suits are pending. However, the number is a far cry from those filed every year in the U.S.

So far the Daiwa Bank suit is the only case in which a court has ordered payment of more than 10 billion yen in compensation. All other rulings have involved far smaller amounts — less than 1 billion yen. Making a fuss about the exceptionally large amount involved in the Daiwa case can be counterproductive. If the shareholder litigation system has the teeth taken out of it, international confidence in Japan’s declining corporations will suffer even more.

The bank suffered a combined loss of $1.45 billion, including the fine paid to U.S. authorities, as a result of lax oversight by the former executives involved. Compared to the loss, the amount of compensation they have been ordered to pay seems reasonable. Some people say the executives’ liability will extend to their children because they cannot pay all the compensation. Legally speaking, however, this problem can be resolved if the right of inheritance is abandoned.

In a shareholder lawsuit, also known as a derivative lawsuit, plaintiffs don’t get a penny if they win; compensation is paid to the company. Their unselfish efforts are laudable. By contrast, the directors’ failure to fulfill their responsibilities deserves criticism and punishment.

During the bilateral trade and economic talks with the U.S., Japan was urged to take a range of remedies, including regulation of insider trading and prevention of bid conclusion in publics-works projects, as well as strengthening of the shareholder litigation system. But progress so far is anything but satisfactory.

Recently the president and vice president of Daiei Inc., the major supermarket chain, resigned over allegations of insider trading involving a Daiei subsidiary. Illegal bidding by constructors continues. All this and more cast doubt over the results of Japan-U.S. trade and economic talks. An attempt to take the steam out of shareholder suits would only increase mistrust in Japan.

Japan is lenient toward economic crime, as evidenced by the paltry fines that are usually leveled. In the Daiwa case, the banks paid a huge fine of $340 million for merely delaying a report to the Federal Reserve Board. By contrast, Mitsubishi Motors Corp. paid just 4 million yen for failing to submit a recall report to the Transportation Ministry.

To deal effectively with globalization, Japan should make greater efforts to enhance the law-abiding spirit of its corporate managers. As a step in this direction, the penalties against law breakers should be toughened.

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