UPDATE 9-Woodford to sue Olympus, drops leadership bid

* Woodford drops 3-mth battle to return to lead Olympus

* Blames lack of backing from big Japan shareholders

* Cites toll his campaign has taken on family

* To sue Olympus for unfair dismissal, begin legal action in UK

* Olympus shares rise 2.1 pct

By Tim Kelly

TOKYO, Jan 6 (Reuters) - The ousted British CEO of disgraced Olympus Corp , who blew the whistle on a $1.7 billion accounting fraud, dropped his bid to return to lead the medical device maker, blaming cosy ties between its management and big Japanese shareholders and saying the saga had taken its toll on his family.

Michael Woodford's campaign against its management rocked the once-proud maker of endoscopes and cameras, but failed to win over Japanese institutional shareholders including Olympus' main lenders, who support a board that has been castigated for insufficient oversight.

"Despite one of the biggest scandals in history, the Japanese institutional shareholders have not spoken one single word of criticism, in complete and utter contrast with the overseas shareholders who were demanding accountability," Woodford told a news conference in Tokyo on Friday.

The decision by Woodford, who was fired in October after just two weeks as chief executive, leaves foreign shareholders who want a new slate of directors, including U.S. fund manager Southeastern Asset Management, without a champion to lead any proxy battle when the company convenes an extraordinary shareholders meeting as early as March.

"We applaud and respect (Woodford's) actions and regret that he has decided to withdraw. Olympus ... continues to suffer under shoddy corporate governance and an utterly discredited board. We maintain that the board should be replaced and a new board should oversee the company's revival," Josh Shores, Southeastern's senior analyst and principal said in a statement.

Another major U.S.-based investor, Harris Associates in Chicago, echoed Southeastern's sentiment.

"It is unfortunate that Mr. Woodford has ended his quest to put together a sound, quality board of directors for Olympus, but the reform process has to continue," said David Herro, chief investment officer for international equities at Harris.

"We still agree with what the independent third-party committee implied - that the entire existing board of directors needs to be replaced, given their involvement in the tobashi scandal," Herro said in a statement.

"All stakeholders need to be working toward the objective of renewal for Olympus, and a new, high-quality board of directors is the first step to be taken."

In a tobashi scheme an investment firm hides a client's losses by shifting them between the portfolios of other genuine or fake clients.

Woodford said he would sue Olympus for unfair dismissal and had instructed his lawyers to begin legal action in Britain. Olympus said in October it fired Woodford because he failed to understand the company's management style and Japanese culture.

"There are no grounds whatsoever for dismissal," he said.

Woodford, looking calmer than at his last news conference in Japan, where he lashed out at Olympus executives and big Japanese shareholders, called his sacking and later developments an "Alice in Wonderland" situation.

"I get fired ... for doing the right thing, and they (current management) are still there," he said.

Woodford, who fled to England after his sacking citing unspecified safety concerns, said the trauma suffered by his wife after he went public with his campaign played a major part in his decision to drop his bid to return to Olympus.

"It's been a frightening period for my wife. I cannot put her through any more anguish," he said in a statement explaining why he was abandoning his battle to be reinstated.

Olympus is being investigated by Japanese police, prosecutors and regulators and U.S. and British authorities over the scandal, in which the firm used dodgy M&A deals to hide investment losses stretching back over two decades. Woodford said he would meet next week with the UK Serious Fraud Office.

LAX GOVERNANCE

The scandal revived concerns about lax corporate governance in Japan and sparked speculation that organised crime syndicates were involved in the Olympus cover-up.

An external panel appointed by the company to investigate the scandal in December issued a scathing rebuke of core management, but found no evidence that gangsters were involved.

The company's main lender and major shareholder Sumitomo Mitsui Financial Group (SMFG) is backing existing management led by CEO Shuichi Takayama, which is seeking a capital tie-up with a rival firm to bolster Olympus' finances.

Olympus' net assets are dangerously thin after it corrected its accounts to include the effects of the 13-year accounting fraud.

Shareholder equity was just 42.9 billion yen ($556 million) at end-September, or 4.5 percent of total assets - less than a quarter of what is seen as a healthy cut-off. A 20 percent proportion of equity would imply that it needs to raise about 150 billion yen in fresh equity.

Japanese media have reported that Sony Corp , Fujifilm Holdings and Panasonic Corp are among those that may ride to the rescue of Olympus.

Japan's big banks such as SMFG and Mitsubishi UFJ Financial Group are often cornerstone investors in Japanese blue chips, with major equity and debt holdings. That puts them in a powerful position to influence board decisions.

In a sign that lenders are in the driving seat at Olympus, the company appointed industrialist Shiro Hiruta, with connections to Olympus' biggest lender SMFG, as the head of an outside panel to advise the firm on a management shake-up.

SMFG, which declined a request from Woodford for a meeting, holds a 3.4 percent equity stake in Olympus as well as 227.5 billion yen ($2.95 billion) in outstanding loans and bonds, according to company data and sources.

Woodford told reporters he thought he could have won a proxy fight, but, in a reference to the lack of support from Olympus' main bank, added: "If I won, what was I coming back to?"

"WEIGHT OFF MY SHOULDERS"

He took aim at Japan's system of cross-shareholdings, in which investors hold shares to cement business ties, as the key reason for poor corporate governance and under-performance, and urged Japanese politicians to legislate against it.

"Cross-shareholding served this nation well post the Second World War. It made this nation into an economic super-power. The situation is not that any more. This nation is going backwards," Woodford told the news conference.

"Cross-shareholding keeps everything comfortable, cosy, nice - no confrontation, no challenge, no takeover."

Nippon Life Insurance Co , one of the firm's biggest shareholders, said it had no comment.

Woodford, who had described his experience after blowing the whistle at Olympus as resembling a John Grisham thriller novel, said he was discussing a book deal of his own.

"I am very motivated to keep preaching the word about how it happened and why it happened," he said, adding his decision to give up on a proxy fight was "a huge weight off my shoulders."

Olympus shares closed 2.1 percent higher at 1,053 yen.

The shares have lost about 60 percent of their value since the onset of the scandal, although they have stabilised as the market gained confidence that the company could avoid a humiliating delisting of its shares that would effectively cut it off from the equity market.

"There are obviously many investors that think that even without Woodford, the company has such a strong market share (in endoscopes) that it has value as a possible for TOB (potential acquisition target)," said Masayoshi Okamoto, head of dealing at Jujiya Securities.