The Japanese hedge fund industry has a growing problem. In light of recent scandals such as the February AIJ crisis, the June arrest of SMBC Nikko executive Hiroyoshi Yoshihoka amid insider trading allegations and the July resignation of Nomura chief Kenichi Watanabe after similar insider trading allegations, more Japanese hedge fund investors are beginning to realize the benefits of transparency, strong operations and more aggressive governmental oversight. Unfortunately, such things seem to be at odds with the DNA of the Japanese business culture which has fostered an environment of secrecy and insider dealings between banks and hedge funds.
While the financial industry in the U.S. has its own problems with insider trading and lack of secrecy, Japan’s problems appear amplified. In Japan, employees that are cooperative members of the larger group are referred to in Japanese as being part of the same house or uhci. Those that dare to challenge the group are often shunned and referred to as being outsiders or soto. Such a climate does not foster, for example investors challenging why a fund manager would decline their business after receiving a due diligence request. To do so would to buck the trend: a no-no in Japan. Yet that is exactly what happened in the case of AIJ.
A second reason why it is so difficult for Japan to embrace more aggressive regulatory oversight of the hedge fund industry is that the modern Japanese business culture still resembles Japan’s feudal era class system. Under this system societal rank or status, which is called chii in Japanese, determined your place in society and how much someone’s opinion mattered, that is if they were allowed to have an opinion at all. Additionally, in feudal Japan samurai’s put the needs of their warlords or daimyo, ahead of themselves even if it meant sacrificing their own lives. There remains remnants of these principals to this day in modern Japan, such as the importance of respecting the honor and status of executives even if wrong doing is suspected, and putting the needs of the company ahead of those of lower status.
The rigidity of these Japanese business principals has been a continued stumbling blog towards promoting the open flow of dialogue or information sharing within organizations and especially not outside of them, to groups such as financial regulators. This seems to be the case even when a Japanese company plans to acknowledge wrongdoing. This was the scenario, as reported by Reuters, surrounding the high level of secrecy preceding the surprise resignation of Nomura’s Watanabe.
A third major reason why the Japanese business climate is likely to stymie efforts at transparency and regulatory oversight in the hedge fund industry is a concept unique to Japan known as the keiretsu. Keiretsu are groups of large corporations which often maintain small ownership shares in each other. Members of the keiretsu often providing funding for each other’s projects and provide ongoing strategic support for each other. Although some may argue that in recent years the keiretsu have begun to lose power, this system is the perfect structure by which affiliated keiretsu member can feed each other insider information and obscure regulatory transparency into transactions through a complex network of affiliated holding companies.
After AIJ, the next scandal to hit the Japanese hedge fund industry involved Edward Brogan and his Whitney Japan Fund, which is under allegations of insider trading in shares of Nippon Sheet Glass.
Brogan had a reputation for being wined and dined around Tokyo by large banks who were eager to gain his fund’s prime brokerage business. The problem the Japanese Financial Services Authority (FSA) alleged, is that in addition to expensive meals, they were also plying Brogan, dubbed the Kind of Tokyo in the Reuters article, with insider information.
As a reward for their valuable insider information, reports claim that Brogan would award additional commissions through so-called tactical points (that is, kickbacks) to provide additional compensation to brokers which provided valuable information. Indeed, such quid pro quo brokerage arrangements are an unfortunately common yet little talked about practice among domestic Japan fund managers.
Specifically, the FSA alleged that Daiwa Securities had provided Brogan’s firm, Japan Advisory, with information about an upcoming offering it was going to be underwriting in Nippon Sheet Glass. The deal would have offered more shares in the company and diluted the share price. With knowledge of this information a hedge fund could short the stock and generate substantial profits. The FSA alleged that Brogan received and acted on this information. According to Reuters Brogan’s funds shorted approximately $6.8 million worth of Nippon Sheet Glass before the offering. The question being asked by investigators is whether the Whitney Japan Fund is a smart investor or had an inside edge?
Acting on such information in jurisdictions that respect the concept of material non-public information would be illegal. However, Japan seems to be a different place in a different time. Rather than conduct their own investigation, suspend the firm’s activities, and pursue criminal prosecution as US regulators did in the Galleon case, Japanese regulators took a very different approach. The FSA instead allowed Daiwa to conduct its own internal investigation into its involvement in the Nippon Sheet Glass deal and determine its own penalties.
Daiwa’s internal investigation found that certain employees had leaked information but the firm did not find evidence that it had systematically leaked insider information. And rather than be subjected to external fines, Daiwa instead issued three month pay cuts to the firm’s senior executives ranging between 10 percent and 20 percent.
Furthermore, the FSA has filed no criminal charges. Since the initial allegations his office has since posted a sign which reads “Temporarily Closed” outside its door and Brogan has left Japan.
Investors seeking to perform an operational due diligence review of a hedge fund manager should inquire into how a hedge fund approaches the research process. Do they utilize expert networks? What about prohibitions on speaking to individuals from public companies? Can the hedge fund manager clearly state their firm’s policy if they are exposed to material non-public information?
Unfortunately, in Japan, as many pension funds learned after the AIJ crisis, such tough operational due diligence questions need to be asked before you end up reading about a fund manager’s problems in the news paper. Without such pressure from investors and the government, hedge fund managers playing on the edge won’t change. After all, why shouldn’t they?
As the Daiwa and Nomura cases illustrate the FSA effectively allows the Japanese financial industry to self-regulate. Furthermore, compared to the US regulators, which conduct independent market surveillance and onsite exams of banks and hedge fund managers, the FSA instead relies on manager-provided reporting for monitoring -- and even that reporting comes with a lag.
As an example, after the Japan Advisory case came to light, the FSA asked the top 12 Japanese brokerage firms to provide details on how they control sensitive information.They had over three weeks to prepare this information and submit it to regulators -- not exactly an immediate response. Furthermore, the Japanese regulators are going to study the information provided by banks to conduct monitoring of this issue -- whatever that means. This information was not independently collected by the regulators, as it would have likely been in the US, but instead the Japanese FSA is relying on the banks to highlight their own issues and design corrective actions subject to their oversight.
Japanese politicians are fed up with the FSA’s light-touch approach. Perhaps taking a cue from increased U.S. prosecution of insider trading and other breaches. they have taken to putting together their own lists of funds that they feel the Japan FSA should investigate. These efforts are being led by the head of the financial affairs committee of Japan’s ruling Democratic Party, Tsutomu Okubo. While it seems Japan may have had a slight wakeup via a Madoff type scare with AIJ, because the regulators are still lagging behind the politicians, it does not seem the message has completely come through yet.
Hopefully the Japanese financial regulators will pursue more aggressive financial oversight and reporting. Similarly, Japanese investors and pension funds in particular should take responsibility themselves for fund manager due diligence and pick up where the financial regulators have let them down, and politicians are trying to catch up. Without this, Japan’s insider trading culture may follow the U.S.’s lead with revelations of a Galleon-scale insider trading type event sooner then we think.
Jason Scharfman is Managing Partner at Corgentum, a consulting firm which performs operational due diligence reviews of fund managers on behalf of and works with investors including fund of funds, pensions, endowments, banks and family offices.
