TheChek News Flow

That Spike in the Job Market Looks a Bit Flimsy. Here’s Why.

At first glance, America’s job market seems to be rocketing back from the shock of the coronavirus. The U.S. economy has added about eight million jobs since the bottom in April, which means full employment would be restored around October if the recovery continues at its recent clip.

Many of the recent gains, however, are the result of a temporary boost that is already dissipating and could even reverse in the coming months, leaving millions of Americans jobless.

When the coronavirus first hit, the surge in unemployment was concentrated in sectors where workers had to be in close physical proximity to customers: restaurants, bars, hotels, casinos, live sports, dentists’ offices, movie studios, passenger transportation, retail, and personal services such as nail salons and barbershops.

Government restrictions and individuals’ health concerns crushed demand and caused employment in those sectors to drop by 32% between February and April. Despite accounting for only 27% of total employment before the virus struck, losses in these categories were responsible for roughly 60% of all the jobs lost between February and April.

By the end of April, the rate of new infections seemed to have peaked, trillions of dollars of federal income support had started to be disbursed, and states and cities were getting ready to reopen their economies. Factories and construction sites that had temporarily shut down resumed operation, diners started coming back to restaurants, and consumers made it back to retailers. The economy had hit bottom and the expansion of the business cycle had begun.

But those gains are unlikely to last. The surveys used to construct the jobs data were conducted between June 7 and 13, which happens to have been the week just before the latest wave of coronavirus outbreaks erupted across much of the South and Southwest. The new outbreaks have already affected consumer behavior in some of the hardest-hit regions, while state and local governments across the country are now in the midst of “re-closing” parts of their economies.

This accelerating spread of the virus threatens to derail the jobs recovery. After all, more than 75% of all the jobs added since April were in leisure and hospitality, retail, personal services, and dentistry, presumably because people had felt safer about engaging in risky activities. Those industries won’t be growing in July and August if the virus is hospitalizing and killing more people than it was in June.

Even without the virus, there are plenty of reasons to worry about the durability of the recovery. The government’s failure to replace lost incomes transformed a crisis that should have been limited in scope into a downturn that’s spread to every corner of the job market.

At the same time, state and local governments, deprived of tax revenue and faced with mounting costs, have been forced to slash employment, resulting in 1.5 million job losses since February. Excluding high-risk sectors, as well as construction and manufacturing, employment has been essentially flat since April.

This is particularly striking for white-collar workers in industries that should have been unaffected by the virus. Initially, they experienced shallower job losses, but the absence of any growth means that their fortunes are increasingly converging with those in the rest of the economy.

The changing nature of the jobs crisis is also borne out in the changing demographics of the jobless. Between February and April, fully 100% of the 17.3 million increase in the number of unemployed came from people who said they were on “temporary layoff,” while an additional eight million workers lost their jobs and stopped looking for work. Since April, the number of Americans saying they are on temporary layoff has dropped by 7.5 million, while 4.6 million have re-entered the labor force.

Unfortunately, this progress has been partly offset by the rising number of Americans who are unemployed but not expecting to return to their jobs quickly, a category that has grown by 2.2 million people since April. Even if everyone who self-identifies as being on layoff were somehow rehired immediately, there would still be 6.8 million fewer Americans with jobs than in February, and the unemployment rate would be over 7%.

Finally, it’s worth remembering that the job gains occurred during a period when the government was sending an unprecedented amount of money to households and businesses. That support is set to end soon, which will put even more pressure on the job market. Unless the government does more to bolster incomes and suppress the virus, the best part of this recovery is already over.

Everything’s gone sideways—and that might be good news for the stock market.

The Dow Jones Industrial Average rose 811.81 points, or 3.2%, to 25,827.36, while the S&P 500 gained 4%, to 3130.01, and the Nasdaq Composite climbed 4.6%, to 10,207.63, to close the week at an all-time high.

That sure doesn’t look like sideways. But nothing happens in a vacuum, and the market’s good week followed a pretty bad one, which was preceded by a good one, which was preceded by a bad one. In fact, the S&P 500 has advanced just 1.6% since June 2, a reflection of the competing forces buffeting markets right now.

On the negative side of the ledger, Covid-19 is still rising—a record 52,000 new cases were reported in one 24-hour period this past week, and not just because of more testing. And states continue to roll back or delay their reopenings, which will push back the recovery’s timeline.

On the positive side: The Federal Reserve is pumping money into the economy, the data have been better than expected—Friday’s June payrolls report, which showed 4.8 million jobs being added, is just the latest example—a Covid vaccine is being developed, and there’s still a good chance that Congress passes some sort of stimulus bill. Depending on the day, news on any one of these fronts could send the market higher or lower.

“The uncertainty regarding this pandemic just fired up again, as infection rates continue to climb in key U.S. regions,” writes Satya Paradhuma, director of research at Cirrus Research. “In many ways, we will continue to witness a market that is ‘Covid-on, Covid-off.’”

Having a plan go sideways is not usually a good thing, but it can be for a market that had come too far, too fast. That’s because it can take some of the extremes out of the market just as easily as a big decline. For instance, the S&P 500’s 14-day relative strength index—a measure of whether an asset is overbought or oversold—has fallen from overbought on June 8 to something approaching neutral at the end of this past week.

“The market is giving us a correction through time, not price,” says John Kolovos, chief technical market strategist at Macro Risk Advisors.

And history suggests that the stock market could continue to rally over the next few weeks. That’s because it tends to rally strongly from June 26 through July 11, Kolovos says, noting that the S&P 500 has averaged a 6.3% rise during that period. If it follows suit this year, the index could hit a new all-time high.

After that, the market tends to weaken, particularly in an election year. To avoid that, the market’s rally will need to broaden out from big tech stocks to everything else. “We need to see fewer stocks going sideways for it to be sustainable,” Kolovos says.

Could earnings season, which starts in two weeks, be the catalyst that helps stocks escape their seasonal pattern? Hans Mikkelsen, credit strategist at BofA Securities, observes that the Citigroup Economic Surprise Index, which hit a record low in April, has surged to its highest level ever as number after number comes in better than expected. The same thing could happen when earnings season begins in earnest in two weeks.

“Clearly investors expect to see horrific numbers overall…but why would the better than expected economic outcome not also flow through to at least better than feared corporate earnings?” Mikkelsen asks. “At the very least companies should be eager to guide the positive trends they are seeing for [the second half].”

We might already have gotten a peek at what things could look like when FedEx (ticker: FDX) reported earnings this past week. The express shipper reported an adjusted profit of $2.53 a share on revenue of $17.4 billion, easily topping the Street consensus of $1.57 a share on sales of $16.5 billion. At that, FedEx stock, which had been down 7% on the year, jumped 12%. And the company didn’t even provide guidance.

Don’t be surprised if you hear more of the same once earnings season gets under way, writes Chris Harvey, head of equity strategy at Wells Fargo Securities. It also has him worried that investors will take some potentially big earnings beats as a sign that business is improving faster than it really is. That could set up stocks for a big rally that could end in tears. “Today, we fear a summertime melt-up (a rally of 10% or more) is an increasing possibility,” he writes.

Maybe sideways isn’t so bad after all.

U.S. Sends Two Aircraft Carriers to South China Sea for Exercises as China Holds Drills Nearby

USS Reagan, USS Nimitz to visit South China Sea’s disputed waters while Chinese navy holds drills there

The U.S. is sending two aircraft carriers into one of Asia’s hottest spots to deliver a pointed message to China that it doesn’t appreciate Beijing’s military ramp-up in the region.

The USS Ronald Reagan and USS Nimitz are set to hold some of the U.S. Navy’s largest exercises in recent years in the South China Sea from Saturday—at the same time that China is holding drills in the area.

With tensions rising between the two over trade, the coronavirus pandemic and China’s crackdown on dissent in Hong Kong, U.S. officials said they wanted to challenge what they called Beijing’s unlawful territorial claims.

“The purpose is to show an unambiguous signal to our partners and allies that we are committed to regional security and stability,” said Rear Adm. George M. Wikoff, commander of the strike group led by the USS Ronald Reagan, in an interview.

The exercises by the two carriers and four other warships will include round-the-clock flights testing the striking ability of carrier-based aircraft.

In recent years, the South China Sea has been the center of Beijing’s effort to project its power farther from its traditional boundaries. China claims sovereignty over almost all of the sea, rejecting claims by neighboring Southeast Asian nations, and it has deployed missiles and jamming equipment on newly built artificial islands to make it harder for the U.S. and its allies to operate in the region.

Its latest military move in the sea started on July 1, when Chinese exercises began around the Paracel Islands, which Beijing seized from Vietnam in 1974. State media said they would run through Sunday.

It is rare for major U.S. and Chinese military drills to take place in the same region at the same time.

Adm. Wikoff declined to specify where in the South China Sea the carriers would operate. He said that the U.S. exercises weren’t a response to the Chinese drills, but that Beijing’s rising military assertiveness justified the U.S. naval presence.

“I think it really helps and serves to validate our operations out here in this region,” he said.

The U.S. has sought to project military strength as China has emerged from the coronavirus pandemic pressuring countries and territories around its periphery. Beijing has increased jet-fighter flights near Taiwan, fought a border skirmish with India and passed a national-security law to limit Hong Kong’s autonomy.

U.S. officials say China may be trying to take advantage of the U.S.’s struggles with the pandemic by stepping up its activity in the South China Sea, a major global trade route.

An international tribunal ruled in 2016 that China’s claims in the sea—which overlap with those of Vietnam, Malaysia, Brunei, Taiwan and the Philippines—have no legal basis. Beijing rejected the ruling and continued with its military buildup.

In May, the U.S. Navy sent three ships to the South China Sea to support a Malaysian oil-and-gas exploration vessel that had been closely monitored by Chinese ships.

In recent years, the U.S. has increased what it calls freedom of navigation operations in the South China Sea, in which its warships sail near Chinese-held islands and other disputed territory.

In late April, China said it had “expelled” a U.S. destroyer that sailed close to the Paracel Islands, which are controlled by China but also claimed by Vietnam and Taiwan. The Pentagon said the operation was completed as planned and was followed by a further similar exercise near the islands in late May.

“The provocative actions of the U.S. seriously violated relevant international law norms, seriously violated China’s sovereignty and security interests, artificially increased regional security risks, and were prone to cause unexpected incidents,” Chinese military spokesman Li Huamin said in a statement following the April operation.

Allies of the U.S. have joined some of its recent naval exercises in the South China Sea, including live-fire drills with the Australian navy in April and maneuvering training with Japan’s navy in June.

The Navy’s preparedness in the Asia-Pacific region was called into question when a coronavirus outbreak crippled an aircraft carrier, the USS Theodore Roosevelt, forcing it into port in Guam for two months through early June. The carrier has returned to service and recently held joint drills with the USS Nimitz in the western Pacific.

The joint operations between the USS Ronald Reagan and USS Nimitz in the South China Sea would be the first time the U.S. has held training with two carriers in the area since 2014.

Oriana Skylar Mastro, a resident scholar at the American Enterprise Institute think tank in Washington who studies maritime disputes with China, said she favored stepping up U.S. military operations with allies in the South China Sea to resist China’s expansionism.

However, Chinese President Xi Jinping could be motivated to take bolder military action in the region that would increase the risk of a confrontation, “particularly if the political situation in Hong Kong worsens, peaceful reunification with Taiwan becomes less likely, or domestic criticism of his management of the novel coronavirus outbreak increases,” Ms. Mastro said.

The USS Ronald Reagan and USS Nimitz will arrive from the Philippine Sea, where they have already spent several days of continuous training, with one carrier flying planes during the day and the other during the night.

“We’re really operating at a higher tempo and simulating a higher end of combat power than we would typically do in a shorter length exercise,” said Adm. Wikoff, the USS Ronald Reagan strike-force commander. “We’re flying around the clock, hundreds of sorties a day in a 24-hour period.”

Chinese warships and military aircraft have tried to interfere with U.S. naval exercises in the South China Sea by sailing close by, directing weapon-targeting radars on U.S. vessels or making threats over inter-ship radio, according to former U.S. naval officers.

The U.S. and China signed a 2014 international agreement designed to prevent accidental clashes between navies by improving communications. But deteriorating diplomatic relations between the two countries have added to the danger, said Lynn Kuok, an expert on Asia-Pacific security at the International Institute for Strategic Studies, a London-based think tank.

“The risk of accidental conflict is still below half but it’s increasing,” she said.

Asked if he had any concerns about holding drills in the same region as the Chinese military at the same time, Adm, Wikoff said: “As professionals, we expect all countries to act professionally and interact professionally while at sea, and we don’t see why this would be any different.”

After Wirecard: is it time to audit the auditors?

The industry’s failure to spot holes in the accounts of several collapsed companies has led to clamour for reform

At the end of 2003, the Italian dairy company Parmalat descended into bankruptcy in an eye-catchingly abrupt manner. A routine bank reconciliation revealed that €3.9bn of cash which Parmalat was supposed to have at Bank of America did not actually exist.

The scam that emerged duly blew apart one of Italy’s best-known entrepreneurial companies, and sent its founder, Calisto Tanzi, to prison for fraud. Dubbed Europe’s Enron, it humiliated two large auditing firms, Deloitte and Grant Thornton, and ended up costing the former $149m in damages. 

Yet it rested on an apparently simple deception: the reconciliation letter on which the auditors were relying had been forged. 

There were shades of Parmalat’s collapse again last week when, nearly two decades later, another fast-growing European entrepreneurial company blew up in strikingly similar circumstances. 

After years of public questions about the reliability of its accounts, primarily from the FT, the German electronic payments giant, Wirecard, was forced to admit to a massive hole in its balance sheet.

Rattled by the failure of an independent probe by KPMG to verify transactions underpinning “the lion’s share” of its reported profits between 2016 and 2018, and unable to publish its results due to issues eventually raised by its longstanding auditors EY, Wirecard finally capitulated. It announced that purported €1.9bn cash balances at banks in the Philippines probably did “not exist” and parted company with its chief executive Markus Braun. Evidence relied on by EY had been bogus. 

It remains unclear exactly how the crucial confirmation slipped through the cracks. According to one EY partner: “The general view internally is that confirming historic cash balances is auditing 101, and [that] ordinary auditing processes were followed, including third party verification, in which case the fraud was sophisticated in its use of false documents.”

Others, however, take a less charitable view of such slip-ups, especially when, as with both Wirecard and Parmalat, they were preceded by so many questions about the reliability of the figures.

“The integrity of the cash account [which records cash and should reconcile to all the other items in the accounts] is totally central to the whole system of double-entry bookkeeping,” says Karthik Ramanna, professor of business and public policy at Oxford’s Blavatnik School of Government. “If there is no integrity to the cash account, then the whole system is just a joke.” 

Wirecard’s collapse is the latest in a wave of accounting scandals that has swept through the corporate world, including UK outsourcing group Carillion and Abu Dhabi-based hospital group NMC Health, as well as alleged frauds at the mini-bond firm London Capital & Finance (LCF) and the café chain Patisserie Valerie.

Many fear a further surge as the Covid-19 lockdown washes away those companies with weakened balance sheets or business models in the coming months. 

Questions about “softball” auditing have dogged many recent high-profile insolvencies. Carillion’s enthusiasm for buying companies with few tangible assets for high prices led it to build up £1.5bn of goodwill on its balance sheet. Despite vast losses at some of those subsidiaries, it had written down the value of just £134m of that goodwill when the whole edifice caved in.

Similar questions hang over LCF, where close reading of the notes in the last accounts it published show how the estimated fair value of its liabilities far exceeded that of its assets in 2017, making it technically insolvent roughly 18 months before it collapsed taking with it more than £200m of savers’ cash. Yet EY gave the accounts a clean bill of health.

Such cases have raised concerns about the independence of auditors, and their willingness to challenge the wishes of management at the client, who are often driven by their own desire for self-enrichment or survival.

“It’s so important if you want to keep the relationship to have a rapport with the finance director,” says a financier who once worked at a Big Four auditing firm. “It is basically sometimes easier to swallow what you are told.”

It is a problem that has deepened with the adoption of modern accounting standards. Over the past three decades, these have progressively dismantled the traditional system of historical cost accounting with its emphasis on the verifiability of evidence and using prudent judgment, replacing it with one based on the idea that the primary purpose of accounts is to present information that is “useful to users”. 

This process has allowed managers to pull forward anticipated profits and unrealised gains, and write them up as today’s surpluses. Many company bonus schemes depend on the delivery of the “right” accounting numbers.

In theory, shareholders are supposed to provide a check on the influence of self-interested bosses. They choose the auditors and set the terms of the engagement. But in practice, investors tend not to assert themselves in the relationship. Scandals rarely lead to the ejection of auditors.

So after UK telecoms group BT announced a £530m writedown in 2017 because of accounting misstatements at its Italian business, the auditors, PwC, were not sanctioned by investors. Far from it, the firm was reappointed with more than 75 per cent support. And when EY came up for re-election at Wirecard in the summer of 2018, despite rumblings about the numbers, it was voted back by more than 99 per cent.

It is not only an auditor’s desire for an easy life that can drain audits of that all important culture of challenge. There are practical issues too. Tight budgets and timetables limit the scope for investigation. 

Audit fees in Europe are far below those in the US. Audits of Russell 3000 index companies in the US cost 0.39 per cent of company turnover on average. Those in Europe average just 0.13 per cent, while for German companies it is a feeble 0.09 per cent.

With fees low, auditing teams are often stretched thin, with only limited support from a partner out of a desire to limit costs and maximise the number of audits done. Audit is traditionally the junior partner in a big accountancy firm, with around four-fifths of the Big Four’s profits coming from the non-audit consultancy side.

Take the last audit of BHS under the ownership of Philip Green, who sold the failing UK retailer to a little known entrepreneur, Dominic Chappell, in 2015. The chain subsequently collapsed the following year.

The PwC partner, Steve Denison, recorded only two hours of work auditing the financial statements. The number two, an auditor with just one year’s post-qualification experience, recorded 29.25 hours, and the more junior team members 114.6 hours. Mr Denison was later fined for misconduct and effectively banned by the audit regulator.

According to Tim Bush, head of governance and financial analysis at the Pensions & Investment Research Consultants, a shareholder advisory group, this reliance on juniors tends to result in “box checking” rather than an investigative approach to audit processes. “Audit teams are less likely to have a feel for the company’s business model,” he says.

This in turn can open the door to abuse. Scams often hinge on faith in some implausible business activity. Parmalat’s €3.9bn cash pile, for instance, was supposed to have come from selling milk powder to Cuba. But an analysis of the volumes claimed suggested that if the company’s numbers were accurate, each of the island’s inhabitants would have needed to be consuming 60 gallons a year.

As the author Richard Brooks noted in his book The Bean Counters: “It shouldn’t have been difficult for a half-competent audit firm to spot.”

The academic Prem Sikka rejects the idea that auditing has gone downhill in the past few decades. “Go back into history and you will find there was never a golden age,” he says.

He argues that most of the weaknesses are of longstanding vintage, and are down to a lack of accountability. “On the audit side, there is no transparency. You have no idea as a reader of accounts how much time the auditors spent on the task and whether that was reasonable,” says the professor of accounting at the University of Sheffield.

While there are signs that the UK regulator is getting tougher, it is down to shareholders to provide stronger governance, Prof Sikka says. If they won’t do it, the government should consider setting up a state agency to commission audits of firms and set fees. “It wouldn’t have to be everyone. You could just do large companies and banks.”

Britain has recently been through a comprehensive review of audit, including how it is regulated and competition in the market, plus a review by the businessman Donald Brydon of its purpose. This devoted many pages to establishing it as a distinct new profession and coming up with new statements to include in already groaning company reports. 

Far from creating new tasks, many observers think that audit should reconnect with its original purpose. This is to assure investors that companies’ capital is not being abused by over-optimistic or fraudulent managers. “At their heart, audits are about protecting capital, and thereby ensuring responsible stewardship of capital,” says Natasha Landell-Mills, head of stewardship at the asset manager Sarasin & Partners.

Yet modern accounting practice has made audits more complicated while watering down the legal requirement to exercise the judgment needed to ensure the numbers are “true and fair”. Despite the endless mushrooming of numbers, it is no easier to know if the capital is really present and can thus justify the payment of dividends and bonuses.

Michael Izza, chief executive of the Institute of Chartered Accountants in England and Wales says auditors need a “renewed focus on internal controls, going concern and fraud. The vast majority of business failures are not the fault of the auditor, but when audit quality is a contributory factor, the problem generally involves these three fundamental areas.”

Mr Bush thinks a radical simplification is in order. “Without clarity there is never going to be proper accountability,” he says. “What we have is a recipe for weak auditing, and ever more Wirecards and Parmalats. In the extreme it facilitates Ponzi schemes. Stay on that route and it won’t be long before you come unstuck.” 

Williams Formula One team looks to a future beyond family

Effort to secure funding will be test of both group’s appeal and broader attraction of F1 as season resumes

Williams, the last family-owned business in Formula One, is grappling with the reality it may have to cede control to the big money that has transformed the sport into an $8bn global business.

Family scion and deputy team principal Claire Williams is one of motorsport’s few women in power, having taken effective control in 2013 of the team her father Frank Williams co-founded. She had hoped her son might follow their lead, but now sees that as unlikely, as Williams Grand Prix Holdings considers a whole or partial sale as part of a strategic review.

“Surviving is difficult for an independent team,” said Ms Williams at the group’s 100-acre headquarters in Oxfordshire. She accepts they “will probably have to operate differently” to secure investment.

The coronavirus pandemic, which stopped the F1 season before it could start, has exacerbated the strain at Williams Grand Prix Holdings, which posted a £17m loss in 2019, down from an £8m profit a year before.

Liberty Media, the US group that bought F1 in an $8bn deal in 2016, has made $1.4bn in cash available to support teams left without sponsorship and circuit income as races were suspended. But the group has itself been forced to renegotiate with lenders, securing amendments to its $2.9bn term loan and an undrawn $500m revolving credit facility, to help F1 survive the pandemic. 

Against this backdrop, the hunt for investment will be a test not only of Williams’ legacy and continued appeal, but also of the broader attraction of the sport to investors as F1 racing resumes on Sunday in Austria.

“We’ve clearly not helped ourselves by finishing last two years in a row, which obviously depresses your income,” said Ms Williams.

But Williams is not alone. McLaren Group, the UK sports car maker which includes the F1 racing team, burnt through £191m of cash in the first quarter of 2020 and has cut 1,200 jobs due to coronavirus. This week it agreed a £150m financing facility with the National Bank of Bahrain, having raised £300m from existing shareholders in March.

Yet the family remained sanguine, said Ms Williams, “working in overdrive in order to protect the team” that controlling shareholder Sir Frank founded in 1977. Bankers from Allen & Co are holding digital conference calls for investors.

Williams hopes to recapture past glories. The team won 16 drivers’ and constructors’ championships in the 20 years to 1997 but no top title since, and has finished last on the grid for two consecutive seasons. The effect on its financial performance has been evident.

Revenues fell to £95.4m last year, the first year turnover has dropped below £100m since 2014. The Frankfurt-listed company is worth roughly half the price of its initial public offering in 2011, when it was valued at €243m. 

In another blow, Williams said in May that it had been forced to terminate its relationship with title sponsor ROKiT early and had launched legal proceedings against the telecoms company.

It hopes to find a replacement in time for next season. The ROKiT deal was worth double-digit millions, according to a person familiar with the matter.

Conserving cash has been vital. In April, Williams completed a debt refinancing backed by existing lender HSBC and Michael Latifi, the Iranian-Canadian billionaire. The company imposed temporary pay cuts and furloughed staff, measures now reversed.

But Ms Williams pointed to structural problems as an independent team due to how F1 revenue is split: “That’s certainly been a factor as to why we [are] in the position we are today.”

Cost caps brought in by Liberty Media should increase the profitability and value of F1 teams, said Mike O’Driscoll, Williams’ chief executive, adding: “We’ve come through two tough years, not a decade of failure as it’s sometimes painted.” The team finished third in 2014 and 2015 and fifth in 2016 and 2017.

F1 has slashed the amount teams can spend in order to balance the competition, from next year introducing a cost cap that was meant be $175m but has been lowered to $145m because of coronavirus. It will fall again to $140m in 2022 and $135m in 2023.

But the pandemic has paused revisions to the so-called Concorde Agreement, which governs how F1 and teams share revenues from television rights, promoter fees and advertising, which amounted to $1.66bn last year.

The existing contract, which expires at the end of this year, includes significant “heritage” payments, handing an advantage to the oldest teams, such as Ferrari, giving them “a whole lot more money . . . before they’ve gone racing”, said Ms Williams.

F1 chief executive Chase Carey, who replaced Bernie Ecclestone following the Liberty Media takeover, hopes to finalise the agreement once the sport is on firmer ground. Talks could resume after the first few races of the upcoming season, said Ms Williams.

“I wish that [the new regulations] had come into play five years ago,” she said. “It certainly provides a much more comfortable landscape for independent teams to be successful.”

Singapore-based fund’s proposal to add three directors to board may prove a test case

A clash between Toshiba and a secretive Singapore-based activist fund is poised to create the first test case of Japan’s highly controversial new national security law on foreign investment.

The row was triggered when the fund, Effissimo, which is Toshiba’s largest shareholder with a 15 per cent stake, submitted a proposal that would have put its founder on the board of the 145-year-old Japanese industrial giant.

Last month, Toshiba rejected the proposal to add Effissimo’s founder and two other non-executive directors to its board. The plan, which Effissimo said was designed to strengthen compliance, comes after recent financial irregularities at one of Toshiba’s second-tier subsidiaries.

The highly public clash with its largest shareholder has erupted at an important juncture for Toshiba, as it tries to draw a line under an accounting scandal in 2015 and a financial crisis which almost took it down.

Under Japan’s newly revised Foreign Exchange and Foreign Trade Act (Fefta), which came into force last month, Effissimo’s proposal could draw government intervention if the move to shake up the board were considered a threat to Japan’s national security.

Toshiba, which is engaged in the nuclear industry, appeared along with 557 other companies that were designated by the government in May as the highest category of national security-related business.

Although the government has stressed that the Fefta regime is not designed to deter or constrain financial investors, foreign fund managers have expressed concerns that the law might be used to hobble activism and have been waiting for a test case to know where the lines might be drawn.

In an unusual move for Effissimo, whose strategy often involves taking very large stakes in blue-chip Japanese companies, it has partnered with Tadashi Kunihiro, a prominent lawyer with experience in unravelling the country’s corporate scandals.

“I agreed with Effissimo that there is still an issue with Toshiba’s corporate culture, and similar scandals could emerge in the future since it lacks a crisis mentality,” said Mr Kunihiro, who proposed the two other directors on Effissimo’s slate.

Effissimo’s investments have frequently caused shockwaves in corporate Japan and raised eyebrows within the government. The fund is run by the former colleagues of Japan’s most famous activist, Yoshiaki Murakami, who was convicted of insider trading in the mid-2000s. 

A Japanese government official said the dispute should be resolved between Toshiba and its shareholders through dialogue, but declined to comment on how the new Fefta law would be applied to this situation.

Effissimo declined to comment.

As part of its punishment for the accounting fraud in 2015, Toshiba was demoted to the second section of the Tokyo Stock Exchange in 2017 and was told that it had to wait at least five years before it could return. In the event, a series of structural changes to the TSE itself mean that Toshiba can now apply for an early return to the more prestigious first section.

A three-month investigation commissioned by Toshiba into the more recent irregularities at its subsidiary, Toshiba IT-Services Corporation (TSC), concluded that employees at the unit were not aware that transactions that inflated revenues were fake.

Mr Kunihiro said that Toshiba’s investigation did not go far enough to identify the root causes of the fake transactions. “It almost seems like Toshiba does not want to make this a bigger issue when it is trying to return to the TSE’s first section.”

Toshiba has said it takes the issue seriously and that it will set up a new compliance advisory meeting to improve its ability to spot potential misconduct.

Yoshimitsu Kobayashi, Toshiba’s chairman, said last month that the board had “no intention of clashing with our shareholders”. Toshiba is proposing to replace one non-executive director on its board, and the competing slates will be voted on at the group’s annual meeting at the end of July.

Toshiba has also previously said it has an “extremely progressive” and balanced board, with 10 out of 12 directors coming from outside the group.