Exchange weighs up Tokyo broker scandal

Investors and former managers of Nikko Cordial, Japan’s third-largest broker, are waiting nervously to find out if the company will be delisted from the Tokyo Stock Exchange and face a criminal investigation into profit padding.

The TSE, expected to rule on the company’s fate next month, says its decision will depend on the level of involvement of senior executives and the degree to which earnings were tampered with.

But the Nikko case has intriguing parallels with Livedoor, the brash internet start-up whose senior managers face criminal charges after an alleged accounting fraud unravelled.

In the Livedoor trial, Takafumi Horie, its former president, has flatly denied charges, but Ryoji Miyauchi, former chief financial officer, admits to charges in his own indictment.

Livedoor raised eyebrows by using multi-strike convertible bonds, also know as death spiral bonds, to raise funds for a highly public hostile bid to acquire Nippon Broadcasting Systems.

This time it is exchange­able bonds that are attracting attention.

In both cases, the alleged frauds revolved round special purpose companies (SPCs) of the sort that became notorious at Enron.

In Nikko Cordial, senior managers are alleged to have improperly kept a special vehicle called Nikko Principal Investment Holdings out of group accounts to allow the parent company to book profits inappropriately.

The FSA in December slapped a record Y500m ($4.1m) fine on Nikko Cordial for failing to consolidate NPIH, which, it said, had allowed the parent company to inflate profits.

Specifically, it said, NPIH had sold an exchangeable bond to its parent company, Nikko Principal Investments, a private equity firm 100 per cent owned by Nikko Cordial. The proceeds were used by NPIH to buy shares in Bell System 24, a tele-marketing company.

Nikko group companies then backdated the ex­changeable bond to enable NPI to make a Y14.7bn profit while NPIH, which issued the bond, made a loss. This backdating and failure to consolidate NPIH had allowed Nikko Cordial to pad profits, the Japanese financial regulator claimed.

An outside investigation committee hired by the company, added that some of the group’s senior managers, including the chief financial officer, were directly responsible for the inappropriate accounts.

Five Nikko executives, including Nikko Cordial’s former chairman, president and chief financial officer, have resigned to take responsibility. But none has admitted wrongdoing.

The committee’s report concluded there had been “systemic illegal activity” by Nikko Cordial executives. Taken separately, each step in the “profit manipulation” scheme was legal, it noted. But when all the pieces were put together, the suspicion arose that each step had been taken “with the deliberate intention” of allowing NPI to book unlawful profits.

Special purpose vehicles are widely used by private equity groups to invest in outside companies, much in the way NPI used NPIH. And it is not unusual for a private equity firm to keep SPCs outside group accounts, to ringfence liabilities and make it easier for investors later.

However, Nikko Cordial in effect controlled NPIH and failed to maintain an arm’s-length relationship with its SPC, as required by law, according to both the committee and the regulator.

Far from maintaining the required distance, NPI was able to falsify the special vehicle’s board minutes – a fact Nikko Cordial now admits, but which it had blamed on a rogue employee.

According to both outside investigations, NPIH issued an exchangeable bond to NPI that gave NPI the right to buy shares of Bell System 24 at the closing price on August 4 2004 of Y24,480.

Nikko Cordial says NPIH issued the exchange­able bond to NPI because it was a cost-efficient way to raise funds to buy Bell’s shares.

Nikko Cordial initially claimed that the NPIH board had voted to launch the bond on August 4, which is why the strike price was set at Bell System 24’s August 4 closing price. But investigators say the decision to issue the bond was actually made on September 22, after the share price had gone up and Nikko officials could be sure NPI would make a profit.

Bell System 24’s share price rose during September, particularly after NPIH launched a bid at Y28,000 a share on September 27.

On June 30 the following year, NPI exercised its right to buy 4.259m Bell System 24 shares at Y24,480 per share. The difference between the price at which it acquired the shares and the actual share price was the Y14.7bn in inappropriate profits Nikko Cordial booked and was penalised for.

Nikko Cordial’s new management says it welcomes the latest independent report, which it commissioned. “We will accept the committee’s indications as the objective facts,’’ says Shoji Kuwashima, appointed to head Nikko Cordial after the scandal broke.

The question for Tokyo’s market watchers is whether Nikko Cordial’s breach merits its delisting and a criminal investigation.

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