The Olympus scandal

Late in 2011 Michael Woodford, a long-time employee, became the first non-Japanese CEO of the Olympus group, the well-known Japanese camera and optical equipment manufacturer. Woodford, a ‘down-to-earth’ British businessman who speaks no Japanese, was not a very obvious choice for the job; according to FACTA, a Japanese magazine, the company had ‘picked a bottom-ranking foreign executive director with virtually no significant responsibilities from amongst a total pool of 25 potential candidates, including the vice-president who was responsible for medical instruments ...’.

Woodford, who had been made President and COO in April, had been passed a translation of FACTA magazine articles in the summer of 2011 that alleged a number of serious irregularities had occurred at Olympus.

• The purchase of three companies between 2006 and 2008 for $910.6 billion. None of these companies had a turnover in excess of $2.6 million, and the acquisition costs were written off without explanation.
• The 2008 purchase of Gyrus, a UK medical equipment firm, allegedly at a grossly inflated price.
• Most of Olympus’s acquisitions – many of which were unsuccessful – had been handled by Global Company, a firm that was alleged to have had an overly close relationship with Olympus.
• A massive foreign currency loss of $1.3 billion for the year ending March 2011.

Woodford conscientiously attempted to make enquiries about the article’s claims, but was stonewalled by the Chairman of Olympus, Tsuyoshi Kikukawa, and the Executive Vice-president Hisashi Mori, among others. In late September FACTA published its October issue, which contained more damaging allegations about Olympus. Woodford demanded to be made CEO, believing that this would give him sufficient authority to conduct a proper internal investigation. The company agreed, but at a board meeting on 30 September it was plain to Woodford that other board members were not cooperating.

Flying to London, Woodford instructed the major auditing firm PricewaterhouseCoopers (PWC) to investigate. PWC produced a report quickly that found Olympus had lost $1,287 million in ‘shareholder value’ in a series of unsuccessful acquisitions and other investments. Woodford sent the PWC report to Kikukawa and Mori, demanding their resignations. Three days later Woodford was fired, and Kikukawa resumed the positions of President and CEO. Woodford then reported Olympus to the UK’s Serious Fraud Office.

The cat was out of the bag. Kikukawa soon had to resign, was arrested, and is currently on trial for falsifying accounts. He has pleaded guilty, but what had really happened? The answer is obscure, and is yet to be fully explained. Back in the 1980s, when Japan was enjoying a massive economic bubble, the US had arranged the Plaza Accord, a deal with other major economies to depreciate the US dollar against the Japanese yen and German mark. This had led to massive drop in Olympus’s income after 1985 as the price of its products had become higher in the vital American market. According to an internal report, Olympus then embarked on ‘aggressive financial asset management’, which suffered massive losses when the Japanese bubble burst in 1990. That year the company had to hide losses of 100 billion yen (then worth approximately $730 million). The losses in ‘financial instruments’ (the report does not give details of what these were) continued to grow, and the firm apparently took steps to disguise and/or defer booking the losses, in the hope that other, more risky investments would generate profits to compensate.

Since the burst of its economic bubble in 1990, corporate Japan, once the terror of less efficient Western industries, has been in the doldrums. As we are often told, Japanese business is different; it is notoriously difficult for foreigners to penetrate the inner workings of Japanese firms, and observers are not optimistic that the ongoing court cases involving Olympus will reveal the full story of what occurred. The consensus at present is that the irregularities at Olympus, such as the ridiculously expensive acquisitions and massive finder’s fees paid by the company, occurred as part of a process of hiding large losses inherited from the 1980s. There are also persistent claims that Olympus had paid large sums to the Yakuza, the Japanese mafia, over the years.

Olympus is not some obscure Far Eastern outfit. It is a long-established firm (founded in 1919) with global brands, and produces excellent, high-quality products. As well as being a leading digital camera manufacturer, it controls 70% of the global market for gastro-intestinal endoscopes, worth $2.5 billion. It is almost 30% foreign-owned, and with numerous subsidiaries established in the West, so the scandal has attracted the interest of the authorities in the US and the UK, including the SEC, the FBI and the Serious Fraud Office.

Japan is, in many respects, a developed ‘Western’ economy. It is a major embarrassment for Japan that a foreign CEO blew the whistle on one of the country’s most important firms. However, it is not clear if the Japanese authorities are prepared to introduce adequate reforms. For example, an attempt during 2012 to introduce a requirement that all listed firms have at least one external director was quashed – but as Olympus did indeed have several external directors who do not appear to have played a significant role in uncovering the fraud, such a measure might not have been effective in any case. According to Jamie Allen, of the Asian Corporate Governance Association, ‘Olympus does reflect many of the problems of corporate governance in Japan that people have been talking about for years ... Whilst not every company may be as bad as this, I certainly don’t think Olympus is an isolated case in terms of its overall weak corporate governance system.’ The Japan Business Federation, known as the ‘Keidanren’, a powerful organisation with 1600 member companies that is widely regarded as the voice of big business, appears to be strongly resistant to any reforms. While the country’s ruling party, the Democratic Party of Japan, came to power in 2009 promising reforms in corporate governance, little has been achieved so far (perhaps partly due to other crises in Japan, such as the 2011 earthquake and tsunami).

It should not be news to investors that Japan has weak corporate governance. The explanations usually offered relate to the country’s culture. As well as the well-known aversion to ‘losing face’ (being humiliated), there are strong tendencies not only to keep problems quiet and try to fix them privately (as appears to have occurred in the case of Olympus)but also to close ranks, especially in the face of foreign criticism. This is generally blamed on ‘Old Japan’ or the ‘Old Guard’, but it is not at all clear that there is any ‘New Guard’ emerging capable of implementing genuine reforms.

In light of this, the much vaunted purchase of approximately 11.5% of Olympus by Sony that was agreed in late 2012 does little to reassure. Sony, which has been making losses for four years, is as much part of ‘Old Japan’ as Olympus. Sony’s injection of $645 million into Olympus will help stave off immediate problems, and there are, no doubt, elements of synergy – for example, Sony makes image sensors for Olympus’s endoscopes – that may bring some tangible benefits for the two firms, but not enough to justify the investment. Foreign shareholders, in particular, are concerned that Sony will be buying newly issued shares from Olympus, which may, depending on the final details, dilute the value of existing shareholdings. Critics see the whole affair as emblematic of the way ‘Old Japan’ protects its own, and predict that little will be done to prevent similar episodes in the future – the company, remember, fraudulently hid massive losses for nearly two decades.

The man who became the ‘Man from Del Monte’

The story of Polly Peck, a small UK clothes manufacturer that grew rapidly into an international conglomerate and becoming a constituent of the FTSE100 (the Financial Times index of the top 100 UK-listed companies) before collapsing in 1990, illustrates an important point for investors: it is possible to make money by investing in a company with fraudulent accounts. If you had got in to Polly Peck in the early 1980s and had sold your shares shortly before the collapse, you could have made a return of more than 1,000%, not bad for holding an investment for less than a decade. This is the temptation underlying the ‘bigger fool’ method of investment, where you make an investment in the hope that a bigger fool than you will eventually take the shares off your hands at a higher price.

In 1980 Polly Peck had been listed on the London stock market for several years, but it was very small and didn’t seem to be heading anywhere exciting. Then a dynamic young businessman named Asil Nadir, a Turkish Cypriot, purchased 58% of Polly Peck for £270,000, and everything began to change. Becoming CEO of Polly Peck in July, he immediately launched a rights issue, successfully raising £1.5 million. This cash enabled him to begin an aggressive programme of growth.

The first place that Nadir looked for opportunities was in Northern Cyprus, a territory that had been set up with the help of Turkey during ethnic troubles on the island in the 1970s. The Turkish Federated State of Cyprus, as it was then called, was not recognised internationally and was suffering a trade embargo. It was in dire need of economic stimulus, and Nadir spotted potential in the citrus industry and in tourism. Over the next few years Nadir was, allegedly, able to obtain commercial buildings, development land and large expanses of citrus plantations at very low cost from the Turkish Cypriot authorities, which were eager to put these properties, many of which had been abandoned by Greek Cypriot owners during the troubles of the previous decade, to productive use. Here was a local son who had made good in London returning to try to help his own homeland in its time of need – it was, in other words, probably far less sinister a series of deals than has often been suggested. Nadir set up three companies in Cyprus: Uni-Pac packaging, SunZest Trading and Voyager Kibris. Uni-Pac was a cardboard box manufacturer, essential for any serious efforts at citrus exporting from Cyprus and Turkey, SunZest handled the fruit, and Voyager Kibris was a tourism company that purchased a Sheraton hotel in mainland Turkey and began to develop hotel sites in Northern Cyprus.

In 1982 Nadir purchased control of another small UK-listed firm, Cornell Dresses, through which he raised further capital, set up a mineral water bottler, Niksar, in Turkey, and in 1984 entered into a joint venture, Vestel, with the British firm Thorn-EMI, to manufacture televisions and other electrical goods. While still under Nadir’s control Vestel became one of the main profit centres for the Polly Peck group, and today both Niksar and Vestel have grown into substantial international brands. Although seemingly a dangerously eclectic collection of businesses, they were in fact well-chosen to exploit the political and economic conditions in Turkey and Northern Cyprus; colour television, for example, only came to Turkey in 1984 and there was a huge demand for low-cost TVs).

Everything depended, however, on the confidence of the City of London. Nadir had a good track record, having built up his own small listed firm, Wearwell, in East London during the 1970s, establishing clothes manufacturing facilities in Northern Cyprus, where labour was cheap. He was also charming and charismatic. Better still, the time was right: under Margaret Thatcher, ‘UK plc’ was expanding and optimistic, enjoying a bonanza as State-owned industries were privatised, generating large profits for stock market intermediaries and bringing a new generation of British investors into the stock market. During the early 1980s, Nadir looked like the kind of dynamic entrepreneur who was wanted in the UK, and his interest in Turkey and Turkish Cyprus, never well-understood in the City, looked like a proposition that, although risky, might pay off big time. By 1983, 85% of the shares not controlled by Asil Nadir were owned by UK financial institutions.

There were, of course, dissident voices. Critics pointed out that the Northern Cyprus ventures, in particular, were acutely vulnerable to political developments – what would happen if, for example, the island was re- unified? Polly Peck had obtained special permission from the Stock Exchange to exclude a breakdown by territory (normally required) in its accounts, which made it impossible for investors to figure out how much money was being made in each country in which the group was active.

But Polly Peck was growing fast, and investors, sensibly, tend to like growth. Its 1982 accounts showed more than three times growth in sales on the previous year, with the bulk of the profits coming from the citrus operations. Significantly, the textile side of the business was making a loss. There had been questions about the high margins that Polly Peck was earning on its fruit; Nadir gave one of the standard explanations used by conglomerates, namely that the vertical integration of the business (growing, packing, transporting and wholesaling) had produced cost-saving synergies and hence higher profits. Although the share price dropped badly on fears that Turkey might remove what were believed to be valuable tax concessions, it recovered and continued its upward trajectory.

In 1984 Cornell Dresses and Wearwell were merged into the Polly Peck group, and for the first time Polly Peck revalued its real estate, giving it a reserve of £8 million which helped to offset exchange rate losses. With the exception of 1985, Polly Peck then revalued its real estate each year until it collapsed. The turnover and profit picture, however, was very rosy. Turnover had grown from £1 million in 1980 to £6.5 million in 1981, £21.1 million in 1982, £62.2 million in 1983, £137.2 million in 1984, and £205.5 million in 1985, with profits after tax during the same period rising steadily each year from a small loss in 1980 to a very healthy £50.5 million in 1985.

With institutional money behind it, Polly Peck just seemed to go from strength to strength. Vestel obtained licences to manufacture for major international electronics firms such as Akai. The group bought British home appliance maker Russell Hobbs and Taiwanese electronics firm Capetronic in 1987, and enjoyed a substantial share price rise in the same year, due in part to it becoming available to US investors for the first time (via specialist mutual funds and ‘American Depositary Receipts’ (ADRs), an instrument that allows Americans to invest directly in approved foreign firms). In 1988 it continued to expand, buying companies and setting up joint ventures in Hong Kong, the US, Holland and Spain, acquiring ten refrigerated ships and nearly doubling its assets. In 1989, at the height of the leveraged buyout boom (see Chapter 2) the US firm RJR Nabisco, itself the product of a very heavily leveraged merger, needed to sell a valuable asset, and decided to put the well-known food company, Del Monte, up for sale. Polly Peck bought Del Monte for $875 million (£575 million), making it the third-largest fruit wholesaler in the world. In the same year, it purchased Sansui, an electronics manufacturer listed on the Tokyo Stock Exchange, as well as a host of smaller firms, and was included for the first time in the FTSE 100 Index. In slightly less than a decade, Polly Peck’s market capitalisation had grown from £300,000 to $1.7 billion, a staggering achievement for a UK-based firm. Nadir himself was now listed as the 36th richest person in the UK.

In hindsight it may seem obvious that there must have been something funny about such rapid growth, but at the time this was less obvious. Not long after it became known in late 1990 that a Serious Fraud Office investigation had begun, the New York Times, usually fairly reliable, opined that ‘the Polly Peck business appears to be sound’. In early August Nadir announced his intention to buy back Polly Peck’s shares in the market (he already owned 25%) and turn it into a private company. The share price rose from 393p to 417p on the news, despite reports that the Inland Revenue was investigating the group for insider trading. Five days later, on 17 August, Nadir announced that he was abandoning the bid, precipitating a change of attitude in the City. Within weeks, the SFO had raided the offices of South Audley Management, a company that handled Nadir’s private dealings, banks holding Nadir’s Polly Peck shares against loans they had made to him began to sell them off quietly, the group’s shares had collapsed and been suspended from trading on the stock market, the company was put into administration and it was becoming clear that there would be a sustained effort in Turkey and Northern Cyprus to obstruct any efforts by the UK authorities to examine the books of Polly Peck’s subsidiaries in those jurisdictions.

The catalyst for the collapse was Nadir’s rapid retraction of his bid to make the group private (breaking Stock Exchange rules), but it is still unclear why he chose to announce the bid in the first place. Some knowledgeable insiders suggest that it may somehow be related to the Gulf War, which had begun on 2 August 1990 and had severely disrupted business in Turkey, which has a border with Iraq, as well as with other Middle East markets. Others have suggested that it was somehow related to insider trading, but investigations into this have produced no tangible results. Yet others have pointed out that Nadir was frustrated at the low price to earnings ratio of the group, which during 1990 was about 8 – a reasonable level, given the dangers of overexpansion for a group that was growing mainly by acquisition. The company itself claimed, on 1 October, that it was the share price collapse following Nadir’s retraction of his bid that had provoked a liquidity crisis in the company; there are strong suspicions, however, that the group had had frequent liquidity crises during the years of expansion.

Whatever the reason, once Polly Peck was in administration many problems began to appear. A substantial part of the value in Polly Peck was supposed to be in the Turkish and Cypriot subsidiaries, but in October a Turkish banker stated that ‘Mr Nadir is not succeeding in selling anything here ... He has no way out now.’ For investors and lenders, the most urgent issue was to establish how much money was in the Near Eastern subsidiaries that might be recovered, but auditors were still unable to gain access to their accounts, owing to court injunctions and in some cases, outright refusal. Attention turned to Polly Peck’s accountants, the first line of defence against corporate governance failures and it was becoming abundantly clear that there were serious corporate governance failures at Polly Peck. The group’s Chief Accountant, John Turner, was expelled from the Institute of Chartered Accountants in 1998, having admitted to his involvement in ‘inappropriate transactions’ and the ‘preparation of inaccurate documents’. Turner admitted ten charges relating to transfers of money from the UK to Polly Peck subsidiaries abroad. Sir John Bailey, Chairman of the tribunal, said that Turner’s behaviour was like ‘clapping the glass to the sightless eye’. Stoy Hayward, Polly Peck’s external accountants, got off lightly, receiving a fine of only £75,000 years later, in 2002, when it admitted a number of complaints mostly relating to failures in monitoring the work of secondary auditors in Cyprus. In 2003 three accountants at the secondary auditors in Cyprus, Erdal & Co., were fined and reprimanded by the UK’s Accountants’ Joint Disciplinary Scheme for having provided audits of the Cypriot subsidiaries to Stoy Hayward that ‘bore no relationship to reality’. For the investors and lenders it was all much, much too late.

The Polly Peck debacle also had a political dimension. Nadir had contributed some £440,000 to the Conservative Party, a sum that opponents are currently demanding be repaid. After Nadir fled to Northern Cyprus in 1993 to escape trial in the UK, Michael Mates, Northern Ireland Minister, resigned after having tried to defend Nadir against the investigations. Much has been made of Mates’s gift of a £50 watch to Nadir with the inscription ‘Don’t let the buggers get you down’ – a little inappropriate, perhaps, but hardly an extreme of wickedness. Because of Northern Cyprus’s peculiar international status there was no extradition treaty, and Asil Nadir was able to live there in style without fear of UK prosecution, a fact that enraged investors and commentators in the UK. In 2010, 17 years after he had escaped to Cyprus, Asil Nadir returned to the UK to stand trial. In 2012 he was found guilty on ten specimen charges relating to the theft of £26.2 million from Polly Peck and was sentenced to ten years, of which, said the judge, he will serve only five.

So why did Nadir return? Part of the reason must be the changed situation in Turkey, the economy of which has developed substantially and now is under enormous pressure to conform to Western standards in business. With his fortune dwindling, Nadir seems to have lost political support in Northern Cyprus, too. It’s embarrassing to harbour a fugitive businessman when you are trying to become more respectable yourself. Furthermore, Nadir’s persistent suggestions that he was somehow victimised in the UK for being ethnically Turkish seems to have worn increasingly thin among Turks and Turkish Cypriots themselves. Enforced exile in rural Northern Cyprus, though pleasant enough, had become frustrating for a man who loved the cosmopolitan high life, according to reports, and Nadir’s inability to travel internationally (for fear of extradition to the UK) had become intolerable, but these factors do not provide the whole answer. One possibility is that Nadir misinterpreted the messages emanating from the UK, and thought he would be exonerated at the trial. Another is that he was deliberately misled by unknown parties into believing this. Perhaps he thought that now the Conservatives were back in power he would get better treatment. He certainly seems to have been genuinely surprised at the verdict.

In recent years Polly Peck has become a case study for business students, and great emphasis has been laid on the group’s ‘currency mismatching’. In Polly Peck’s case, currency mismatching meant borrowing in strong currencies like the pound and the Swiss franc at low rates of interest and investing it in territories using soft currencies like the Turkish lira at high rates of return. This had the effect of bolstering the profit and loss account while driving down the balance sheet. In the present writer’s view, however, this is not the crux of the wrongdoing at Polly Peck. The crucial point is that British accountants and auditors were willing to accept false information emanating from Polly Peck’s subsidiaries in Turkey and Northern Cyprus during the 1980s, and investors in the UK (and later the US) relied upon these assurances.

They had to, given that Turkey and Turkish Cyprus are not well understood in the UK. This was a serious failure of the accounting profession in the UK, and although it led to the Cadbury Report, which attempted to raise standards of corporate governance, investors cannot have total confidence in the value of audits, especially in situations involving subsidiaries in countries that don’t work on the Anglo-Saxon model of business (see page 156).

Investors versus business shamans

From a private investor’s perspective, the shenanigans at Olympus and Polly Peck are less serious than many of the other cases discussed in this book, not least because few investors can have thought it appropriate to sink their entire wealth into a single company. More importantly, the underlying businesses were solid, not fictional as in the cases of Madoff and Stanford. Olympus makes great products for which there is worldwide demand. Polly Peck’s businesses were mostly sound, and some of them, such as Vestel, the TV manufacturer, have prospered greatly since Polly Peck’s collapse. In Olympus’s case the wrongdoing relates to the concealment of losses incurred during the really excessive Japanese bubble of the 1980s when most, if not all, large Japanese firms committed egregious investment errors. This was compounded by Olympus’s ‘financial engineering’, the details of which have not been revealed. The executives who maintained the cover-up for so many years do not appear to have done so for personal gain, but out of loyalty to the company and their predecessors. Since the Japanese bubble burst UK investors have generally been advised to avoid Japan, with its countless ‘zombie companies’ receiving continuous government bailouts or unable to repay their debts, its ‘Lost Decade’ of the 1990s and its continuing dire need for more corporate transparency. It would have taken a brave private investor in the UK, therefore, to have decided to take a punt directly on Olympus or any other large Japanese firm.

The attractions of Polly Peck were rather greater for British investors. It was a creature of its time, when a pro-business government was trying to encourage the general public to invest in the stock market. The ethos in the City of London was short-termist and somewhat cynical – the financial institutions that backed Polly Peck may well have been operating on the ‘bigger fool theory’, as has often been suggested, and to have placed less faith in the accuracy of the company’s accounts than did the small investors who followed them in. But in those days, even private investors often regarded short-termism as the only sensible way to invest – you got into a company that had the political and commercial wind behind it, and hoped to get out before anything went wrong – and for nearly a decade nothing did go wrong. While this is not a sound way to manage your entire portfolio, it is not entirely unreasonable to do this with a small proportion of it (see Chapter 12). This may sound like a rather amoral attitude, but successful investors do sometimes allow themselves to practise a little judicious opportunism, and take a risk on a booming firm whose accounts are less than ideal. If they lose out, of course, they really cannot put all of the blame on others.