Collateral Damage

4 minute read
Richard Katz

At first glance, what made the livedoor scandal so dramatic was that it triggered a sharp stock-market correction. The rally that preceded this two-day panic had gotten ahead of itself, with the Nikkei 225 index soaring 40% since last August. In just six months, the price-to-earnings (PE) ratio for Japan’s 1,600 biggest firms had shot up from an average of 18 to nearly 23 on the eve of the raid on Livedoor. The Internet company itself had a bubbly PE of 130, giving it a market value of $6.3 billion. Much of this market euphoria was driven by foreign investors, who made a record $9 billion of net purchases of Japanese stocks in 2005. At the same time, Japanese individuals treated the market like a casino, buying and selling rapidly online and accounting for nearly 40% of all trades. This is precisely the kind of heady, get-rich-quick atmosphere in which greed gets out of hand and swindles thrive.

Livedoor triggered the correction, but it could just as easily have been something else. Sooner or later, the rally will resume because foreign investors remain confident—indeed overconfident—in the Japanese economy. But what’s more important over the long haul are the implications of the Livedoor mess for corporate reform.

Casting himself as a rebel challenging stodgy old men, the company’s flamboyant leader, Takafumi Horie, had become a poster child for entrepreneurialism. Focusing on growth by acquisition, he turned Livedoor into an Internet conglomerate of more than 50 firms, often using its stock to buy the targets. All along, those in the know said he was a flawed business strategist. Compelled to drive his stock price higher to boost his purchasing power, he’s now accused of using illegal tactics to maintain momentum.

Regardless of the truth of the allegations, Horie’s aggressive maneuvers have had unintended consequences, strengthening the hand of those stodgy businessmen against whom he was rebelling. Last year, some corporate barons used Horie’s challenge as a pretext to seek even more protection through poison pills and the like—even though not a single hostile takeover has ever succeeded in Japan. They got the Diet to delay a reform that would have facilitated more foreign acquisitions by making it easier to pay with cross-border stock swaps rather than cash. Undoubtedly, the old guard will try to use the current scandal to tarnish the reputation of freewheeling capitalism. In fact, conspiracy theorists suggest that the prosecutors are exacting revenge on Horie. That’s doubtful. Japan’s prosecutors don’t usually conduct such raids until they believe they already have a good case. It would hardly be the first time that an upstart company in Japan used unsavory tactics to break into the closed ranks of entrenched corporate leaders.

Whatever the investigation uncovers, Japan’s corporations still need a lot of reform. Rather than forming ever-larger conglomerates, firms need to strip down to core competencies. It should be easier for new entrants to challenge current leaders with above-board methods. Japan needs more shareholder power, not more protection for entrenched management. Tokyo needs to remove hindrances to foreign direct investment, and to end shady practices that feed fears of rigged prices. The stakes are huge. Overly optimistic foreign investors, extrapolating from current trends, see Japan growing at 2-3% for years to come. But any economy operating far below full capacity can enjoy a temporary burst of growth via new demand. The problem is that Japan’s working-age population is set to shrink by 0.5% a year, which means the only source of long-term gdp growth is improving labor productivity. It will take further corporate reform to create the necessary productivity revolution. It would be tragic if the alleged malfeasance of one maverick were allowed to hinder this reform. On the other hand, if Tokyo uses this incident to clean up dubious stock market practices, the incident could end up accelerating progress. The answer lies in Tokyo’s hands.

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