Financial Authorities Pack a Punch

But foreign firms complain they are too often the sparring partner of choice.

Let's face it: Investors don't trust Japan's financial markets -- especially the securities markets. Despite Japan's enormous savings rate and its incredibly low interest rates, individual investors are still wary of participating in the securities markets. Even the Securities and Exchange Surveillance Commission (SESC) chairman, Takeo Takahashi, says that the low level of participation among individual investors could be the result of what he calls the "three distrusts," namely, distrust of market intermediaries, distrust of market participants, and distrust of market regulators. "We didn't ask each individual investor what he thought of the market, but by looking at the current investment environment, [these distrusts are some of the reasons] why individual investors do not actively participate in securities trading," says Takahashi. His job is to kick out rogue brokers and dealers, sweep away securities crimes, and show the world what the SESC can do. The SESC was formed in 1992 after a series of financial scandals gave rise to a need for an effective body to inspect and monitor securities brokers and markets. The SESC conducts compliance inspections and investigations into possible violations of laws and regulations. It also does market surveillance, and when a violation is found, it makes recommendations to its parent, the Financial Services Agency (FSA).

The SESC is becoming more visible year by year, industry watchers say. Especially since 1997, the number of SESC recommendations to the FSA has been on the rise, hovering between 35 and 40 cases a year. The SESC recently announced that it will increase the frequency of regular compliance inspections for medium-size firms and foreign firms from once every three years to once every year and a half. It has also asked the government to double its staff for inspections and investigations.

Together with the SESC, the FSA is also active in giving out "administrative sanctions" to punish the bad guys. Currently, the FSA concentrates on inspecting the financial soundness of firms, while the SESC concentrates on fairness, legality, and transparency of transactions. Separately from the SESC, the FSA's Inspection Bureau, whose main duty is to examine banks and insurance companies, is also responsible for checking out the financial soundness of securities companies.

This year alone, the FSA has given administrative sanctions to such big-shot firms as Kokusai Securities, Societe Generale Securities, Goldman Sachs, Mizuho Securities, and Tokyo Mitsubishi Securities.

But the foreign financial community in Japan is not very happy about the way it is being treated. A couple of recent cases have stoked foreigners' resentment because, according to one industry source who asked not to be named, foreign firms were treated harshly for "seemingly minor issues."

The story of ING Barings' Tokyo branch is a case in point. In May, an analyst at the firm released a highly critical report about Daiwa Bank. Daiwa's share price went down significantly following the report's release. However, authorities homed in on two minor numerical mistakes in the report. A subsequent FSA investigation resulted in an order to improve the company's research operations and business. ING Barings subsequently published a correction and an apology in several Japanese daily newspapers. In response to the order, ING Barings' spokesman, Sheel Kohli, says, "We cooperated fully with FSA officials and responded immediately to implement all the measures pointed out by the FSA. We take compliance with the FSA very seriously and will continue to monitor and strengthen our regulatory compliance and internal control systems."

But the authorities were concerned that ING Barings may have traded as many as 250,000 Daiwa shares before the report was released, according to a report by the Nikkei Shinbum. A source tells J@pan Inc that the firm did sell shares of Daiwa, "But it was after the information in the report was available to the public. Even the FSA admits that. The order was simply to improve the firm's research operations to avoid repeating the same kind of mistakes. It was not related to the selling of the stock." The FSA lifted the business improvement order imposed on ING Barings on September 26.

The controversy left a scar on foreign analysts. "It was like being punished for telling the truth," says a vice president at a foreign securities firm. "Now analysts are afraid of saying negative things about Japanese companies." He adds that that may be exactly what the government wanted -- as stock markets have sputtered recently, he says, the government may be trying to prevent foreign analysts from writing anything negative about Japan in order to support falling share prices.

Another incident that drew resentment involved Goldman Sachs, which released an inaccurate quote for its covered-warrant financial product, e-warrant, in May. (Covered-warrants are high-risk, high-return derivatives that entitle the holder to buy a specific company's securities if that company's share price goes up to a certain level.) The figure was left on its Web site for 30 minutes. According to Goldman Sachs, it was a system error and the price it put out was almost 24 times higher than it should have been. Goldman Sachs voluntarily notified the FSA about the mistake shortly after the fact, but the FSA reacted by suspending the company from trading covered-warrants for two weeks. The firm was also suspended from issuing new covered-warrants for a month.

Industry sources say these mistakes were too obvious to warrant such harsh treatment. "Anyone with common sense would have understood these were simply mistakes. They were being picked on," says a source at a foreign securities firm who wished to remain anonymous. The suspension order caused Goldman Sachs serious financial damage, and, the source adds, "Guess who gained from that? Japanese companies."

"A number of foreign executives have asked me whether I think the FSA is witch-hunting [foreign firms]," says Christopher P. Wells, a lawyer at White & Case LLP. The way the FSA reacted "makes experienced industry professionals laugh," he says, since this was not "criminal behavior, but an input error, or a quotation error." He adds that he doesn't consider it a witch-hunt, but that "it does not seem like the behavior of an experienced regulator which is seeking to guide the market through its actions."

According to Wells, while it is normal for a government agency to examine financial institutions, and every jurisdiction in Asia has regular examinations and inspections, many observers think FSA examinations have been very different, extremely tough, and unprofessional -- especially when they focus on foreign firms. "The SESC inspectors are felt to be more reasonable, knowledgeable, and competent [than their FSA counterparts], but they also lack predictability and consistency in enforcement," says Wells.

According to industry sources, the SESC focuses too much on issues it considers hot, often ignoring vital issues. For example, the SESC never seems to be interested in cracking down on "broker churning" (a broker asking his customers to sell certain securities because the broker has new products he wants to sell to that customer). The practice is prohibited in Japan, but sources say it is widespread.

As for the SESC's choice of issues to target, "It is as if the organization is simply reacting to media reports, or it is doing its job just because somebody [influential] might have complained," says one source. "They don't seem to know where they are going or have an overall plan to protect investors and market participants."

Despite the criticism, some of the SESC findings and FSA administrative orders seem to be well-intentioned, and serve to demonstrate that they really are trying to do something to clean up the mess.

"Some of the violations the SESC found this year are quite serious and intolerable," says Toyomi Takimoto, a former SESC inspector who now privately practices law. Takimoto notes that some violations related to equity exchangeable bonds (EBs) involved manipulative transactions. In instances involving UBS Warburg Securities, Commerz Securities, and Tokyo Mitsubishi, for example, traders kept selling stocks by placing a series of lower-limit or no-limit orders just one or two minutes before the market closed. As a result, the price of those stocks plunged in both cases, and these firms avoided paying additional interest (bonus coupons) on the EBs. Additional interest is calculated daily based on the stock price at the market's close.

"The problem is that some traders didn't really think that was a problem. I heard some complain that it made economic sense to do that," says Takimoto. There are also cases in which these companies had received similar warnings before, but repeated the same mistakes, he adds.

The fact is that Japanese authorities are not "picking on" only foreign securities firms, but also Japanese firms. Kokusai Securities was particularly hard hit perhaps because of the seriousness of the violation it committed -- lying to an inspector. The case resulted in a suspension of business for all branches of the large securities firm, and it marked the first time Japanese authorities took such extreme measures. The FSA also ordered the company to reshuffle personnel, and the firm's chairman, vice-president, and the head of the Osaka branch, who lied to inspectors, resigned.

All securities firms in Japan are facing the sting of the authorities' whip. And the authorities are using that whip with a little more force these days. But Wells says if the FSA's job is to increase transparency and credibility in Japanese securities markets, "They are making a big mistake. You know why? Because people are extremely disappointed by these incidents. There is no sense of trust. Even the old MOF (Ministry of Finance) was better."

That takes us back to one of the three distrusts: distrust of market regulators. Getting rid of this distrust may take longer than the authorities think. @