Toshiba’s perennial accounting problems have led to a groundbreaking proxy contest. Effissimo Capital Management, the $9 billion activist fund led by former colleagues of Yoshiaki Murakami, launched the first-ever proxy fight in its 14-year history of activism to improve Toshiba’s internal controls, just a year after it contributed to a board overhaul along with two other funds. Underscoring its frustration, Effissimo is also willing to be the first activist to test Japan’s freshly adopted national security law that some feared are designed to protect domestic companies from foreign activists.

Whatever the government’s decision, the vote on July 31 is expected to be a narrow win for Toshiba, multiple sources familiar with the matter told Activist Insight Online. Around 63% of the shares are held by foreigners, down from nearly 70% in March. Farallon Capital Management, a 2.1% shareholder, said it will vote for the dissidents. Another smaller shareholder that declined to be identified told Activist Insight Online it will also vote for the activists. But with proxy advisers siding with the company, most institutional investors are likely to give the incumbents more time to show results.

Indeed, most of the existing board members, including the three foreigners on the board, have been in place for a little more than a year. Asking them to radically transform the corporate governance in such a short span at a company operating in an environment notoriously slow to change might be too much.

Effissimo nominated three directors but it is not the only one seeking board representation this year. 3D Investment Partners, a much smaller fund, nominated two directors in a parallel proxy contest. The two funds’ platform is different. Effissimo is worried about the new accounting scandal that emerged in January 2020 and Toshiba’s response to it, while 3D is more focused on the board’s performance.

Scandal again

Albeit small, this year’s accounting fraud raised concerns that the new directors have failed to change the weak internal controls and corporate governance that led to several massive scandals over the years, including the Westinghouse debacle in 2015 that almost took down the company.

The latest mishap involves round-tripping transactions by subsidiary Toshiba IT Services (TSC) to inflate sales and profits. Because the sums involved are small (around $190 million) and hardly material to the stock price, Toshiba initially did not give it much attention, running an investigation and concluding that TSC managers were largely innocent.

Yet this has raised the ire of Effissimo, the company’s largest shareholder with 15% of the shares. “It is a case of ‘one bad apple that spoils the barrel’ not ‘one isolated bad apple’,” Effissimo said in a presentation to shareholders viewed by Activist Insight Online.

Since the investigation report was revealed in February, Effissimo had 13 teleconference calls with either management or independent directors. Yet it said it was “unable to get comfortable that management is taking this incident with a similar level of gravity to us.”

Unlikely partnership

Effissimo teamed up with highly-respected lawyer Tadashi Kunihiro, who has been a key investigator of the country’s largest corporate scandals and set the standard framework for how they should be approached. For the Japanese, the collaboration raised eyebrows, as Effissimo, a highly-secretive hedge fund, is still regarded as a short-term activist. Kunihiro himself selected two candidates with corporate compliance track records to nominate on behalf of Effissimo, namely Takeuchi Akira and Sugiyama Tadaki. Effissimo complemented the slate with its founder, Yoichiro Imai.

Toshiba opposes the election of both Effissimo and 3D’s candidates, saying the size of the current board is optimal. Electing all the dissident nominees would result in a board with 17 members, as neither Effissimo nor 3D opportunity submitted proposals to remove directors.

Yet this might be a small price to pay for a board with improved oversight, according to Effissimo. Toshiba “did not investigate the root cause” of the accounting problems, Takeuchi told Activist Insight Online.

“Toshiba has replaced their board members, and they might have come up with many ideas, but I’m wondering if middle management and on-site operation understand well enough to execute those ideas,” Sugiyama said, adding he played a key role as a “nerve line connecting the head and neck to the body as an external board member of Kanebo,” a Japanese cosmetics company. Sugiyama and Takeuchi could act in the same capacity at Toshiba, performing more work on the ground.

Government protection

To nominate Imai, Effissimo has had to undergo government scrutiny. With Toshiba now deemed important to Japan’s national security interests, Effissimo had to make an application to the Ministry of Finance to be able to vote for its founder Imai and have him on the board.

A spokesperson for Effissimo confirmed that Imai is regarded as a “person of interest” and submitted the request under the new rules, which aim to prevent foreign governments from gaining control of companies critical to national security. The person declined to elaborate on whether the request was approved. A representative of Japan’s Ministry of Finance in London declined to comment “due to sensitivity of such information.”

If Effissimo’s request is confirmed, worries that the new regulation will stymie activism have no foundation, according to Alicia Ogawa, an expert on Japanese corporate governance.