Legal Inside Information Used for Years in Japan Is Suddenly Taboo

  • Earnings preview notes disappear as analyst tips scrutinized
  • Japan lacks U.S.-style fair disclosure rules for listed firms

Pedestrians holding umbrellas walk past an electronic stock board outside a securities firm in Tokyo, Japan, on Wednesday, July 8, 2015. Japanese stocks fell, with the Topix index dropping by the most in more than a year, amid concern that ChinaÕs equity rout is spreading.

Photographer: Tomhoiro Ohsumi/Bloomberg

For years in Japan, it’s been one of the stock market’s biggest open secrets: By the time companies reveal their earnings to the public, the most plugged-in traders have known the numbers for weeks.

Their clairvoyance had nothing to do with superior analytical skills, but stemmed instead from the country’s lack of U.S.-style fair disclosure laws. Listed businesses in Japan can selectively share material information with whomever they want -- and it’s long been customary for executives to give analysts early peeks into their quarterly results. The tips flowed to brokerage clients via “earnings preview’’ reports, allowing investors to digest the numbers well before their official release.

QuickTake Abenomics

Now, that system is changing, and it has big implications for Japan’s $4.8 trillion stock market. At least five major brokerages have banned analysts from talking to companies for preview notes, jolted into action by an official censure of Deutsche Bank AG’s local research unit in December and a regulatory report last month that called for new disclosure rules. The impact so far has been striking: The proportion of companies missing profit estimates has climbed to the highest since 2011, earnings-day stock swings are near the biggest in 30 quarters and analysts’ forecasts are the most widely dispersed in two years.

Proponents say the change will create a more level playing field for individual investors and discourage an unhealthy fixation on short-term corporate targets. For the research units of brokerages, it represents a fresh threat to a business that’s already getting battered by falling commissions. Japan’s stock analysts will have to find new ways to add value as their role as conduits for corporate information gets squeezed.

“Until recently, you could look at the preview reports, and once you’d seen two or three, you’d be able to grasp the general outcome,” said Naoki Kanemoto, a Tokyo-based senior fund manager at Sumitomo Mitsui Asset Management Co., which oversees about 12 trillion yen ($109 billion). “From now on, there will be more surprises.”

Toyota Shocker

The increased regulatory scrutiny of selective disclosures comes as Prime Minister Shinzo Abe’s administration tries to lure more individuals to the stock market and improve Japan’s corporate governance. The benchmark Topix index has dropped 13 percent in 2016, making it the world’s third-worst performing major market behind China and Italy. The gauge rose 0.6 percent at 10:50 a.m. local time on Thursday.

For more on earnings previews, click here.

Under Japan’s old system, the level of cooperation for preview reports varied by company, according to a Tokyo-based analyst who’s been covering stocks at a major brokerage for more than 10 years. Some firms would reveal their exact profits and projections, while others would disclose segmented results, leaving analysts to deduce the overall bottom line, the analyst said, declining to be identified because he wasn’t authorized to speak on the matter. Some companies would only say whether results were above or below expectations, he said.

The practice was legal, and so widespread that investors could find preview reports on nearly every stock with analyst coverage, according to Kanemoto.

Results this month from Toyota Motor Corp., Japan’s largest company, show what can happen when those reports disappear, said Mitsushige Akino, a Tokyo-based executive officer at Ichiyoshi Asset Management Co. Shares of the automaker sank as much as 4.5 percent on May 12 after it surprised analysts with a net income forecast of 1.5 trillion yen for the year ended March 2017, trailing the 2.19 trillion yen average of 23 estimates compiled by Bloomberg.

When Toyota reported results last year, by contrast, the official release was preceded by at least seven preview reports, with most estimates for operating profit falling between 2.77 trillion yen and 2.8 trillion yen. Toyota announced a figure of 2.75 trillion yen, and shares slipped just 0.5 percent on the first trading day after the results. The company declined to comment.

Japan’s legal and regulatory system enabled preview reports to thrive. Under the country’s Financial Instruments and Exchange Act, companies are allowed to make selective disclosures of material nonpublic information, as long as they do so without the intention of inciting a trade. 

Changing Forecasts

In the U.S., by contrast, firms must make all material information available to the public at the same time, or “promptly” in cases of accidental disclosure. The rules, known as Regulation FD, were enacted in 2000.

While Tokyo’s stock exchange asks companies to disclose material information to the public as quickly as possible, bourse rules give firms significant leeway. A change of less than 30 percent in a profit forecast, for example, could go unreported to the public.

Japan has no regulations preventing analysts from talking to companies about their earnings before their official release. Researchers are banned, however, from using material nonpublic information to “solicit” client trades.

That was the rule cited by Japan’s Financial Services Agency when it censured Deutsche Bank’s securities unit in December. The FSA brought a similar administrative action against Credit Suisse on April 25, though neither of the brokerages were fined. Both firms have issued statements saying they’ll work to prevent similar incidents from happening again.

Regulators may have used the Deutsche Bank and Credit Suisse cases to signal a newfound intolerance for selective corporate disclosures through brokerages, according to Sumitomo Mitsui’s Kanemoto.

“When the regulators come in with their administrative action, both analysts and the companies have to become more conservative,” he said.

Brokerages Respond

The FSA, which said in a report last month that it’s “necessary to consider in detail the introduction of fair disclosure rules in Japan,” declined to comment on preview reports.

Japanese securities firms, sensing a shift in the regulatory environment, are already making changes. Spokespeople from Credit Suisse and four of Japan’s five top-rated brokerages in the latest Nikkei Veritas ranking, including Nomura Holdings Inc. and Daiwa Securities Group Inc., confirmed that they no longer allow analysts to interview companies in the run-up to earnings releases. Some brokerages now instruct employees to use publicly-available data as the basis for their preview reports instead.

It’s difficult to completely stamp out selective disclosures, according to Antony Page, a professor at Indiana University’s Robert H. McKinney School of Law in Indianapolis. Even after Reg-FD, academic researchers in the U.S. have found evidence of information changing hands during one-on-one company meetings at investor conferences. In Japan, corporate earnings are routinely revealed in the Nikkei newspaper before their official release, without attribution.

Still, results for the quarter ended March suggest surprises will become more common. Earnings missed estimates at 58 percent of Topix members with at least one analyst forecast, while the average stock swing after results swelled to 4.5 percent from 3.3 percent a year earlier.

While some of the surprises may stem from increased volatility in the yen and uncertainty over the global economic outlook, Ichiyoshi Asset’s Akino says the lack of preview reports has played a big role.

Analysts who want to stay relevant in a post-preview world will need to prove they can help clients pick winning stocks, said Soichiro Monji, chief strategist at Tokyo-based Daiwa SB Investments Ltd. Global investment banks may cut their research budgets to $3.4 billion by 2017 from about $4.5 billion last year, according to estimates by Frost Consulting.

“The fundamental purpose of analysts should not simply be to relay information they’ve gathered from the companies,” Monji said. “It’s to conduct various analyses in order to advise on investment decisions.’’

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