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By Damion Rallis, Senior Research Associate

The past few weeks for Japanese automaker Toyota Motor Corporation (ADR) (NYSE:TM) perfectly encapsulate the recent rollercoaster ride of one of the world's most powerful car companies. While the news that Toyota reclaimed the title of world's largest carmaker is certainly something for investors to cheer about, it is offset by yet another massive recall along with a class action suit settlement valued at over a billion dollars. The question is not whether Toyota has what it takes to compete in the short-term, but rather if its management culture is sufficiently equipped to be the innovator to an increasingly design conscious consumer, and if this ability can be matched with the operational know how to prevent headline grabbing recalls from eroding its brand equity.

Currently, Toyota's AGR Rating-a measure of the integrity of accounting and governance practices-is "Average," its "D" rating for ESG reflects a high level of long-term sustainability risk. Further, GMI Ratings' Litigation Risk model has been flashing warning signs for several rating periods. The company's score is 10 (on a scale from 1 to 100), meaning "High Risk." This places the company in the 10th percentile of all companies in North America, indicating higher shareholder class-action litigation risk than 90% of all rated companies in this region.

In August 2009, a driver in a Toyota-manufactured vehicle called 911 to report a stuck accelerator pedal. The call ended with the sound of a crash; all four passengers were killed. One month later, Toyota recalled 3.8 million US vehicles but insisted that there was no "vehicle based cause for the unwanted acceleration allegations." In November 2009, Toyota amended its floor mat recall to include the gas pedals of more than 4 million vehicles. Then, in January 2010, the company recalled another 2.3 million vehicles in the US to fix faulty accelerator pedals that can "wear down over time, sometimes causing the pedal to jam." In February 2010, US Transportation Secretary Ray LaHood sharply criticized Toyota for dragging its feet on safety concerns over its gas pedals, suggesting the automaker was "a little safety deaf" to mounting evidence of problems.

Despite Toyota's protestations, CEO Akio Toyoda formally apologized to customers and then announced that the company had commissioned an independent research organization to test certain auto mechanisms and that the company would set up a Special Committee on Global Quality. In the end, Toyota recalled about 11 million vehicles and was found to have deliberately concealed US safety issues to avoid the costly implementation of recalls and safety fixes. The US Transportation Department pushed for the largest fine permissible against Toyota because the company failed to promptly notify officials about potential safety problems and "knowingly hid a dangerous defect for months from US officials and did not take action to protect millions of drivers and their families."

In fact, according to testimony in a class action lawsuit, Toyota's former legal counsel testified that the company maintained "a secret 'Books of Knowledge' containing engineering and design information related to defects, including unintended acceleration issues in Toyota vehicles, and countermeasures taken by the Company to correct those defects without disclosure." The testimony went on to say that "Toyota made a practice of concealing safety problems, failed to disclose information it was obligated to produce during litigation, and paid multi-million dollar product liability settlements where it feared that plaintiffs' lawyers were getting too close to discovering the existence of the Books of Knowledge."

Unfortunately, however, Toyota's product recalls, regulatory fines, and litigation settlements are not yet a part of the company's past. Toyota announced in December 2012 a $1.1 billion settlement related to class action lawsuits over the 2009-2010 recalls. Overall, Toyota's costs related to the recalls will likely exceed $3.1 billion, although the company has declined to reveal these total costs. Toyota continues to face two separate lawsuits related to the 2009-2010 recalls, a consumer-protection and fraud suit in California and an unfair-business-practice case brought by the attorneys general of 28 US states.

Also in December 2012, The US Transportation Department fined Toyota $17.35 million in civil fines for failing to report safety defects to regulators within five days as required by law. As part of the settlement, Toyota and its US subsidiaries agreed to make internal changes to their quality assurance and review of safety-related issues to improve their ability to take into account the possible consequences of potential safety-related defects. In October 2012, Toyota announced a recall of 7.4 million vehicles due to a potential fire hazard involving power-window switches. In November 2012, Toyota recalled around 2.8 million vehicles due to problems with the steering mechanism and the hybrid system water pump. Lastly, Toyota announced last week that it would recall 1.3 million vehicles for defective airbags and windshield wipers. What is not clear is if these continual recalls reflect material manufacturing issues, or if they are the result of institutional memory that continues to be highly sensitized to potential product liability.

According to a report from the Wall Street Journal, "The 2009/2010 recalls and public scrutiny of accidents involving its vehicles-including congressional hearings-dented Toyota's reputation for quality and undermined its sales. Its U.S. sales were flat in 2010, a year in which almost every other major auto maker posted gains, and ended its 30-year unbroken run of market-share increases in the U.S." The effect of recalls of this nature-especially ones related to violent crashes in a car-crazed culture such as the United States-should not be underestimated. According to the Pew Research Center's Project for Excellence in Journalism, in the first week of February 2012, 11% of US news coverage focused on the Toyota recalls.

In a GMI Ratings report entitled "Northeastern Asia: Corporate Governance Laggards," we state that "Toyota's post-mass-recall response to the pressure for bettering governance epitomizes the ways Japanese corporations handle the demand for improved governance. Pre-recall, up to 2010, Toyota's board was filled entirely by 29 executives. The massive recall proved that a large number of advisory committees had failed to provide an outside perspective to the board (or that their 'advice' had fallen on deaf ears). In 2011, Toyota promised to introduce comprehensive governance reforms. The board size has since been cut in half, but all of its 13 directors are executives or scions of the founding Toyota family."

Simply put, it is difficult to maintain faith in Toyota's board to provide effective oversight over Toyota's operations. Not one of its 13 members stands as an independent voice to Toyota culture and its controlling Toyoda family. While it is not uncommon for the boards at Japanese automakers to be stuffed with executive directors (9 of 12 Honda directors, 10 of 12 Suzuki directors, and 8 of 9 Nissan directors are not independent), this is certainly not the case at some of Toyota's non-Japanese competitors: only 2 of 20 Daimler directors are non-independent while only 2 of 16 Ford directors and only 2 of 12 General Motors directors have ties to their prospective companies.

Toyota's board is currently lead by Chairman Fujio Cho, who has been with the company since 1960 and has served as a director. On top of his Chairman duties, Cho is also Corporate Auditor of DENSO CORPORATION; Director of Central Japan Railway Company; Director of Sony Corporation; President and Representative Director of Toyota Kuragaike Kaihatsu Kabushiki Kaisha; and Director of Toyota Industries Corporation. While Reuters reported a few weeks ago that the Chairman may be on his way out, the man said to take his place-current Vice Chairman Takeshi Uchiyamada-is not exactly bringing a fresh perspective, as he will be 67 in August, joined Toyota in 1969, and has been on the board for 15 years.

The potential decline of innovation resulting from a lack of independent and fresh thinking leadership may be Toyota's key long-term weakness. Not only are there no independent board members, but the average director has served with the company since 1975. An article this week from Business Insider suggests that "Japanese products have lost their lustre, and that consumers won't necessarily flock back to Japanese products because they are not viewed as innovative or edgy." Further, another report from Business Insider called "10 Brands With Huge Credibility Issues In 2013" reiterates the obvious, that Toyota's numerous recalls "have cast a once-respected company in a bad light." Despite the company's willingness in 2010 to commission an independent research organization to dig its way out of the recall and its surrounding PR disaster, no attempts have been made to inject an independent perspective on its own board.

While revenues are increasing-a 36.1% increase in net revenues from fiscal 2012 to fiscal 2013-the reality is that annual net revenues continue to lag seriously behind previous totals-down from 26.3 trillion yen in 2008 to 18.6 trillion yen in 2012. Even with first half revenues of 10.9 trillion yen in fiscal 2013, the company will be hard-pressed to come anywhere near its past highs. So while there is certainly reason to celebrate, we shouldn't avoid the reality of the situation. Toyota ultimately serves as a great example of how we can rate a company a "D" despite short-term success, as short-term gains often conflict with the potential drag of long-term weaknesses. While we certainly acknowledge the success of a company that is now the world's #-1 carmaker, we can't help but wonder if the company's poor governance structure ultimately inhibits its ability to not only maintain but improve upon its successful brand. Indeed, if Toyota's recall culture is here to stay-especially if there are any more visceral and disturbing stories like those from 2009-consumers may eventually turn to Toyota's many competitors.

Disclaimer: GMI Ratings is an independent provider of research and ratings on environmental, social, governance (ESG) and accounting-related risks affecting the performance of public companies. GMI Ratings is a registered investment adviser and is therefore subject to certain reporting requirements. Specifically, per our ethics policy, our analysts are precluded from engaging in any transactions involving any companies we follow. Our ratings and supporting research are intended to provide investors with an effective summary of ESG and forensic accounting factors that can and do impact issuer risk. They are not, however, intended for stand-alone use and should not be considered as simple Buy, Sell or Hold recommendations. We encourage investment professionals to regard these ratings as a specialized, proprietary input to be used in combination with existing fundamental analysis or other approaches and to help comply with the UN-PRI (United Nations Principles of Responsible Investing) and similar standards.

Source: At Toyota The Song Remains The Same: More Recalls And No Independent Directors