Insider Trading in Japan: The Nomura Case

Nomura

Nomura Group is one of Japan’s largest financial conglomerates. Nomura was established in 1925, and acquired most of Lehman Brothers Asia, certain of Lehman’s operations in Europe and the Middle East, and the Lehman Brothers’ service platform in India[1] in 2008.  The Nomura Group has a broad range of services and products, such as securities, international and domestic IPO underwriting, asset management, and capital investment. Nomura is considered Japan’s largest and most powerful securities company[2].

An insider trading scandal at Nomura Group shakes the Japanese conglomerate to its core.  In 2010, market participants claim there is suspicious trading in deals Nomura is underwriting.  Inpex (an oil and gas producer), Tokyo Electric Power, and Nippon Sheet Glass report suspicious trading activities prior to the issuance of new shares in their companies.  From these reports, the Japan Securities and Exchange Surveillance Commission (SESC) launches an investigation, which leads to the definitive discovery of insider trading by Nomura sales officers.

Why is Insider Trading Ethically Wrong?

Insider trading occurs when the stock of publically held corporations is traded on (i) material and (ii) non-public information[3].  The individuals charged with insider trading may be insiders within the company in question, or outsiders entrusted with the non-public information (tipper) or they may be those who obtain the information from an insider (tippee).  John R. Boatwright defines the key points for the occurrence of insider trading:

• the trader has violated some legal duty to a corporation
• the source of the information has a binding legal duty and
• the trader knows that the source is violating that duty[4]

In arguments against insider trading, the ethics focuses on property rights and fairness.  When a person takes material information that has not been made public, and makes trades based on that knowledge, that person is stealing from the corporation in question. The corporation with the non-public information is said to own that information. In terms of fairness, trading on information that is not public is unfair to the corporations and to other market investors because those who have the inside information have an unfair advantage[5]. On a systemic level, insider information results in the stock market being an  unlevel playing field. Ultimately, the practice leads to a decline in trust in the markets and a fall in participation, which is deleterious for proper functioning financial markets.

Japanese Law on Insider Trading

In the United States, insider trading is prosecuted under SEC Rule 10b-5.  While the punishment for insider trading varies depending upon what occurred and the severity of the actions committed, it is clear that actions of insider trading, if detected, will be punished, regardless of whether financial benefit was received.  Insider trading is punishable (may be subject to criminal prosecution) by either jail time or fines.

In Japan, there also are laws against insider trading. While the Japan SESC has recently begun to crack down on insider trading, due partly to the recent spate of insider trading, the agency does not aggressively prosecute or punish insider trading offenders.  The criticism about light punishments challenges the current structure and is prompting the Japanese SESC to consider harsher punishments.

Facts of the Case

In 2010, Nomura participated in several underwriting deals, in which suspicious trading activity was reported prior to the issuance of new shares for the companies involved.  On October 31^st, 2012, the Japanese Stock Exchange fined Nomura Securities Company 200 million Yen ($2.5 million) for the insider trading scandal[6].  Additionally, Nomura CEO Kenichi Watanabe and other executives resign due to insider trading within Nomura. The scandal severely hinders Nomura Group from becoming a serious rival to Wall Street giants in the banking industry[7].  The revelation of insider trading at Nomura, the fall in its stock price, deal revocation of underwriting projects, and leadership turnover demonstrate the consequences of insider trading on a corporation.

As early as 2010, sales representatives share certain information with hedge fund managers and bankers outside the Nomura.  The information pertains public offerings in which Nomura is an underwriter. These deals take place primarily in Japan.  Departing Nomura executives in July 2012 acknowledge that employees leaked information on at least three public offerings in 2010 to favored fund managers, who then profited from short-selling ahead of the expected drop in the share price[8].

Participants in the Japanese market complain for some time that non-public information is leaked prior to the issuance of new shares in a secondary offering.  Additionally, the leaked information often results in the shorting of stock of the issuing company, and a buy back after the new shares are released[9].  Issuing new shares dilute the outstanding shares and thereby reduce the share price.  On this information, shorting the shares likely actualizes a profit when the share price had drops.

On reports of insider trading, the Japan Securities and Exchange Surveillance Commission launched an investigation.  It discovers that investment bankers at Nomura, responsible for selling securities to investors outside of the bank, have in fact shared non-public information with hedge funds, foreign fund managers, and others regarding the issuance of new shares.  The accusations of insider trading have led some experts to believe that the problem began in 2008, when Nomura acquired a large stake of the Lehman Brother’s foreign operations.  The desire to achieve larger scale and bigger profits may have been factors that diverted Nomura’s attention away from compliance, even at a time when banks were facing more scrutiny than ever[10].

Additionally, the desire of Nomura employees to meet sales targets also appears to have been a factor in the events that led to insider trading.  Insiders report that employees “would be willing to do almost anything to meet sales targets”[11].

On each of the insider trading cases in 2010, Nomura employees reportedly gave tips to fund managers regarding the three public offerings that were affected.  The fund managers, one located at Chuo Mitsui Asset Trust (who received information on the Mizuho and Inpex new share offering) and another located at First New York Securities (who received information for Tokyo Electric), were ones that took the information and made trades accordingly.  In each case, the insider at Nomura did not make the trades themselves or profit from the information[12].

Due to the scandal, Nomura lost the underwriting deals in Japan, and faces further pressure on its balance sheet. Insider trading is known as a common occurrence in Japan. Foreigners often criticize the Japanese practice of hyping up the market prior to the release of shares. Nomura employees did not appear to benefit directly from trading in insider information. However, they probably received promises of more business from fund managers, which would result in higher bonuses.

Since the revelation of insider trading at Nomura, there have been severe consequences.  The architect of Nomura Groups extensive expansion through the acquisition of Lehman Brothers foreign operations in 2008, Kenichi Watanabe, as well as a chief lieutenant Takumi Shibata, resigned in July 2012[13].   These officers that took a 50% pay cut in June 2012 while the investigation was being conducted.  Additionally, Nomura’s net profit fell to Y1.98 billion ($25 million) to close the second quarter, which was a 90% decrease from the Y17.7 billion reported in the second quarter of 2011.   Japanese regulators widened their investigation to include other banks and brokers, such as Nikko SMBC Securities and a Tokyo Hedge fund Asuka Asset Management.  Nomura was dropped from a list of companies chosen to underwrite new deals, such as those for Japan Tobacco (a deal worth about $6 billion), Japan Housing Finance Agency, and Resona Holdings[14].  Additionally, in October 2012, the Tokyo Stock Exchange fined Nomura Y200 million ($2.5 million) for the insider trading scandal[15].

Ethics of the Players

The main players in this scandal are Nomura (executives, employees, and shareholders), other banks and brokers (Mizuho Securities, Goldman Sachs, JPMorgan, etc.), the corporations that enlisted Nomura and other brokers to underwrite new share issuances (Tokyo Electric Power, Inpex, Nippon Sheet Glass, etc.), the Japan Securities and Exchange Surveillance Commission, and the Japanese stock market.

The conduct of Nomura (its directors, employees, and executives) was negatively affected by lax internal controls and excessive pursuit of profits[16].  As a global financial institution Nomura has the duty of care to ensure its clients, shareholders, and the market are treated equitably.

The employees of Nomura, specifically those in charge of the sale of newly issued shares, broke their ethical duty to their clients and the market by allowing the desire to achieve sales goals and profit to distract them from their responsibilities as fiduciaries.  The sales employees have an ethical responsibility to protect the sensitive, material, non-public information entrusted to them by their clients. Without their care to act in an ethical manner, the markets would not be fair, as some are privy to non-public information before others have access to the same information.  As John R. Boatwright notes, the information that is used in insider trading is unavailable to the general public not for lack of effort on the public’s part to obtain new market information, but is rather unavailable due to lack of access[17].  The information that is material and non-public is kept that way for a reason.

The reason can be as simple as the process of a merger taking place, or the issuance of new shares, as in this case.  The bottom line however, is that non-public information cannot be given due to the unfairness and the loss of trust that it can cause.  In this case, the Japan SESC was concerned about the potential of scaring investors away from the Japanese markets.  The conduct of the sales employees at Nomura who gave inside information to hedge fund managers and other parties violated the trust bestowed to them by clients in particular and the market as a whole.

An interesting point is the employees at Nomura were not prosecuted for their actions.  Some of them received disciplinary actions, and others were fired, yet none of them were prosecuted by the Japan SESC.  Under Japanese law, a person can only be punished for insider trading if she directly profited financially from the trade.  In this case, none of the Nomura employees in investment banking, underwriting, or sales were prosecuted, as none profited.  Rather, their primary reason for insider trading was to pass information to short sellers who then created demand for shares during the public offerings.

The executives and directors at Nomura have a similar, but slightly different, duty.  While they did not personally commit insider trading, the executives are responsible for ensuring business is administered with proper care, both in ensuring compliance and in meeting clients’ needs.  After the acquisition of Lehman Brothers, the culture at Nomura changed.  In an effort to become a global banking competitor, Nomura sacrificed compliance for  profits.

The executives at Nomura, namely CEO Kenichi Watanabe and his chief lieutenant Takumi Shibata, failed ethically. Insider trading occurred on their watch because these two top executives allowed a culture of blatant non-compliance and lax controls to develop.  Nomura appears to have thrown compliance out the window, for the sake of ensuring that demand for new share issuances was high.  Many companies never have to deal with insider trading, but for a company to be charged with a minimum of three cases of insider trading in one year is outrageous.  The number of cases of insider trading at Nomura in 2010 reflects poorly management’s oversight and controls on their investment bankers.  The executives at Nomura owe their clients and the market a fiduciary duty, to ensure that their business is done with the highest ethics in order to ensure that the Japanese market is a fair place to trade.

The other financial institutions in this case are also blameworthy, whether they were Nomura’s competitors competing for deals, foreign banks, or hedge funds that received the inside information. The foreign banks that received the inside information also acted unethically.  To act on inside information is a clear violation of ethical conduct.  It is surprising how willing and quickly the other banks took the information from Nomura and shorted shares.  Based on the fairness argument, the actions of hedge fund managers and other banks were a violation of the fairness principle.

Japan’s Light Punishment for Insider Trading

Insider trading in the United States receives harsher penalties, such as fines, jail time, or both, for any individual that knowingly participates in the exchange of non-public information.  In Japan, insider trading has become a near epidemic problem, as the punishments for insider trading are not yet serious enough to deter individuals from committing insider trading.  Part of the banking culture in Japan, as exhibited in this case, appears to expects the exchange of non-public information as the order of business.  While the Japan SESC investigates and punishes insider trading, it is unable to curb the near epidemic volume at this time.

The Japan SESC is taking stronger steps to combat and deter insider trading.  In the past year, the Japan SESC has sought fines against three investment firms in a total of four cases of insider trading uncovered[18].  First New York Securities, which is one of the recipients of inside information (from which they made a profitable short sale), was fined $185,000 by the Japan SESC.  Remarkably, this is actually one of the harshest fines levied by Japan SESC[19].

Despite increased fines against foreign and domestic banks that commit insider trading, the Japan SESC has been surprisingly lax in the monitoring, control, and regulation of insider trading.  Critics, in light of the scandal at Nomura, are calling for harsher punishments for insider trading.  The general criticism of the Japan SESC is that the punishments are too light and do not deter individuals or entities from insider trading.

A reason why insider trading is “business as usual” in Japan is because insider trading does not normally warrant criminal charges.  Rather than the threat of prosecution, an inside trader  needs only to worry about any fines she may receive from the Japan SESC, which tend to be extraordinarily light.  Some cases are prosecuted, however these constitute only a handful of the most egregious cases. Criminal prosecution involves a high burden of proof and requires coordination with public prosecutors[20].

The United States has a recent record of prosecuting individuals who leak inside information.  In the United States, Nomura employees who shared inside information would be prosecuted for their roles in the release of the information[21].  In contrast, in Japan, not one individual in the Nomura insider trading scandal has been sanctioned or prosecuted.  Rather, Nomura was simply ordered to implement preventive measures, including ethics training and stricter monitoring of communication with clients[22].

Given the information discussed above, the penalties are not sufficient punishment for the insider trading that took place at Nomura.  The absence of criminal prosecution, heavy fines, and punishment for all parties (not just those that profited from the information) argues for the case that the Japan SESC is not currently doing enough to deter and reduce insider trading.  Regardless of whether individuals in Japan face social consequences for actions such as insider trading (e.g. stunted career prospects, lost jobs, etc.), there still must be strong and enforceable ramifications for those who violate the fairness of the market through insider trading. Yet, Japan is likely to persist in its practice of not placing tougher penalties to deter offenders.

Following this scandal, Nomura, like other international banks who acted badly, is still recovering and hoping to move on as lightly scathed as possible, from its insider trading scandal.  However, while the clients the company lost may eventually return, the damaged reputation and credibility could have a lasting impact.  Nomura’s ethical lapse may prove to be a costly mistake.
By: David Barnes

Citations

Boatright, John Raymond. Ethics in Finance. 2nd ed. Malden, MA: Blackwell Pub., 2008. Print

Emoto, Emi, and Nathan Layne. “Nomura CEO Quits as Insider Trading Scandal Widens.” Reuters. Thomson Reuters, 26 July 2012. Web. 19 Nov. 2012. <http://www.reuters.com/article/2012/07/26/us-nomura-ceo-idUSBRE86P03S20120726>.

Hyuga, Takahiko, and Russell Ward. “Japan’s Insider-Trading Carousel.” Business Week. Bloomberg Business Week, 09 Aug. 2012. Web. 19 Nov. 2012. <http://www.businessweek.com/articles/2012-08-09/japans-insider-trading-carousel>.

Layne, Nathan. “Japan Calls for Tougher Insider Trading Rules.” Reuters. Thomson Reuters, 11 June 2012. Web. 19 Nov. 2012. <http://www.reuters.com/article/2012/06/11/us-japan-insider-regulations-idUSBRE85A01Y20120611>.

Nakamoto, Michiyo. “Nomura Admits Insider Trading Mistakes.” Financial Times. Financial Times, 29 June 2012. Web. 26 July 2012. <http://www.ft.com/intl/cms/s/0/da348c24-c1d7-11e1-8e7c-00144feabdc0.html>.

Nakamoto, Michiyo. “Nomura States Its Regret after Insider Trading.” Financial Times. Financial Times, 21 Mar. 2012. Web. 26 July 2012. <http://www.ft.com/intl/cms/s/0/58b68af8-7353-11e1-aab3-00144feab49a.html>.

“Nomura Holdings | History.” Www.nomuraholdings.com. Nomura Holdings, n.d. Web. 18 Nov. 2012. <http://www.nomuraholdings.com/company/group/holdings/history.html>.

“Nomura Slapped With Fine in Insider Trading Case.” Business Week. Ed. AP NEWS. Bloomberg Business Week, 31 Oct. 2012. Web. 18 Nov. 2012. <http://www.businessweek.com/ap/2012-10-31/nomura-slapped-with-fine-in-insider-trading-case>.

Tabuchi, Hiroko. “Nomura Chief Resigns Over Insider Trading Scandal.” Nomura Chief Resigns Over Insider Trading Scandal Comments. New York Times, 26 July 2012. Web. 19 Nov. 2012. <http://dealbook.nytimes.com/2012/07/26/nomura-chief-resigns-amid-insider-trading-scandal/>.