Spiraling Out of Control

In the late 1990s, a U.S. IT company incorporated a subsidiary in Japan (“Hashi-co Systems”) to sell the company’s products into the lucrative Japanese market. Upon receiving orders in Japan, Hashi-co purchased goods from the U.S. headquarters and then sold them to a network of distributors, which, in turn, resold them to the end customers. 

Typically, the distributors would pay Hashi-co for the goods 30 to 60 days after Hashi-co had shipped them, and then the end customer would pay the distributors at a later date. The distributor, therefore, bore some of the financial burden due to the time lag.

Hashi-co’s sales grew for many years and recorded increasingly large sales with certain distributors including “Ichi-co,” a subsidiary of a significant Japanese technology company. This success was mostly attributed to “Mr. Sato,” the representative director of Hashi-co. With Mr. Sato directing the sales strategy, business grew at a much greater rate than predicted.

Each month, Mr. Sato reported to his managers at U.S. headquarters. There were few aged accounts receivable (for example, more than 180 days), and most sales were cleared by cash receipts (for example, minimal bad debt). The volume and value of the sales to Ichi-co weren’t considered to be an issue because Ichi-co was selected as a distributor because of its size, its reputation in Japan, and its large customer base.

Also, there was a long-standing relationship between Mr. Sato and Ichi-co’s representative director, which was seen as an asset in gaining a foothold in the Japanese market. Combined with the perception that Japan is “low risk” (Japan is ranked 17th on Transparency International’s 2009 Corruption Perceptions Index), managers at U.S. headquarters saw little reason to be concerned about Hashi-co’s performance in Japan.

However, in early 2009, things changed. Amid the general economic downturn, Hashi-co’s accounts receivable began to age significantly. More alarming, however, were Ichi-co’s subsequent allegations. Ichi-co claimed that Mr. Sato had conspired with another trading party, “Omizu-co,” which often acted as another intermediary party in transactions, to entice Ichi-co to enter into certain resale transactions on the promise that payment to Ichigo-co was certain. Because Omizu-co was a newly incorporated, small company with a weak credit rating, Mr. Sato bound Hashi-co to guarantee Omizu-co’s debts to Ichi-co. With the general tightening of available credit in early 2009, Omizu-co began delaying its payments to Ichi-co. Ichi-co alleged that it was out of pocket because of Hashi-co’s assurances. Therefore, it viewed Hashi-co as liable for amounts due.

In view of these allegations, U.S. headquarters appointed forensic accountants to analyze the transactional documentation, the general ledger, bank statements, and inventory records to assess the validity of Ichi-co’s claims. At the same time, Mr. Sato resigned and refused to cooperate with the investigation.

WHAT WAS DISCOVERED 

After many months of piecing together data, the forensic accountants determined that Hashi-co’s seemingly successful business was made up almost entirely of fictitious circular transactions.

The investigation revealed there was never any movement of goods among the parties, even though money was exchanged. The transactions were circular in that Hashi-co was both the first seller and last buyer of the goods. The forensic accountants discovered a warehouse in which a significant amount of the product purchased intra-company was stored. Ichi-co and Omizu-co participated as intermediary parties in the transaction chain, making payments 1 and 2, respectively, without receiving or delivering the goods. The structure of a typical transaction is shown in Figure 2.

The transactional documents for the circular chain often were executed on the same day; however, the delivery dates (and so the applicable payment dates) were spread 30 to 60 days apart. Figure 3 shows a typical timeline for payment and “delivery” of goods for a circular transaction with the three companies – A (Hashi-co), B (Ichi-co), and C (Omizu-co).

Ichi-co and Omizu-co benefited from the scheme because the transactions artificially inflated their revenue and balance sheets (accounts receivable). Ichi-co and Omizu-co also made a small profit margin on each “resale.”

While Hashi-co reaped inflated balance sheets, it paid a price – losing money on each transaction because its payment to Omizu-co included the margin collected by both Ichi-co and Omizu-co. It appeared that Mr. Sato had entered into a few fictitious circular transactions to modestly inflate Hashi-co’s revenues and then got stuck in a vicious cycle in which new circular transactions were needed to fund prior transactions.

WHY ARE THESE SCHEMES SO PREVALENT IN JAPAN? 

Many cases of circular transactions are never exposed because commercial disputes in Japan often are settled quietly without litigation. But cases involving publicly listed companies and large amounts of money are drawing the attention of prosecutors and the press. (See sidebar below for two recent cases from the Japanese media.)

In our experience, several factors unique to Japan have contributed to an environment conducive to circular transactions:

1. It’s common for smaller trading companies in need of temporary financing to ask larger trading partners for assistance. In certain circumstances, Japanese financing laws allow for trading houses to provide financing without a license. These transactions are documented as sale of goods transactions, making Japan an unusual business environment. A circular transaction is not only legal, but it’s an accepted business practice among private companies. (Publicly listed companies in Japan must comply with securities legislation, which can impose severe penalties on a company and its directors who allow a misstatement on the company’s financial statements.)

2. Japanese business culture promotes deep and long-standing relationships among senior personnel of trading partners. As a result, when one party is approached by another party to assist financially, they often will provide it.

3. Routine business transactions are conducted with a much higher degree of trust than in other parts of the world. In circular transactions, there’s often little or no documentation to indicate the true nature of the transactions.

4. All companies incorporated in Japan (Kabushiki Kaisha, or K.K.) must have a representative director, which is the most senior position within a company. This person has the ability to bind the company in any contract. Therefore, proof of authority to enter into a transaction isn’t normally requested by transaction counter-parties. This makes it easier for a subsidiary’s representative director to enter into transactions without the knowledge and approval of the parent company.

5. When the contractual validity of circular transactions is tested in commercial disputes, the courts assess them in a vacuum. In other words, they determine whether each sales contract is valid and enforceable in itself without considering wider issues, such as:

• The economics of the transaction schemes (in this case, the losses suffered by Hashi-co, and the profits taken by Ichi-co and Omizu-co for participating in the scheme)
• The financial impact of the transactions (the fact that Hashi-co, Ich-co, and C-Co artificially inflated their revenues and balance sheets)
• The misrepresentations or other fraud indicators (such as including false end customers in the transactional documentation)

THE COURT’S MINDSET 

Generally speaking, circular transactions are regarded as sales rather than financing regardless of the actual intended purpose. When faced with a dispute between two intermediaries involved in a “sale of goods” transaction chain, Japanese commercial courts will take into account general business practices when reviewing the contract between the parties. In many cases, when a seller (i.e., Ichi-co) claims for payment under a contract, the purchaser (i.e., Omizu-co) puts forth a defense of simultaneous performance, stating that a payment is due only upon delivery of goods. However, this defense rarely succeeds, because intermediary parties don’t receive and redeliver goods in a transaction chain. Because the defense of simultaneous performance seeks to impose conditions not intended in the original contract, the courts generally hold that it fails as a defense. In these circumstances, the seller (Ichi-co) most often is awarded damages in the amount that was due under the contract.

There are limited circumstances in which the Japanese commercial courts have held a transaction in a circular scheme to be invalid. One example included a transaction in which the goods being bought and sold never existed; the description was a fictitious, random combination of letters and numbers in the transactional documents.

ACCOUNTING AND OTHER REPERCUSSIONS 

Discovery of circular transaction schemes frequently leads to accounting and disclosure issues for all parties involved.

The following table summarizes the requirements for revenue recognition under U.S. GAAP and IFRS:

[This table is no longer available. — Ed.]

Under any of the three standards, it’s easy to see how Mr. Sato’s circular transactions failed to meet the requirements to recognize revenue; in no case did physical delivery of product occur. As a result, Hashi-co was forced to restate its revenues for the current and prior three years under U.S. GAAP. The subsidiary also had to correct various other accounts related to the transactions including accounts receivable and inventory (because the “sold” product had been transferred off the balance sheet and stored in a secret warehouse).

These adjustments were material to Hashi-co as a whole and therefore required disclosure to investors. Hashi-co was also forced to disclose a material weakness in its system of internal controls. In addition to bearing the expense of an extensive investigation, Hashi-co’s stock price in the United States took a significant decline upon its disclosure, and its reputation in the Japanese market was similarly tarnished.

While all the parties in a circular transaction scheme generally benefit with increased revenue, it’s interesting to note that one party normally bears a disproportionate share of the repercussions from accounting and disclosure perspectives. While Hashi-co suffered all of the repercussions noted above, this wasn’t the case for Ichi-co. As an immaterial subsidiary of a major Japanese company, the impact of the fraud wasn’t material to Ichi-co’s parent. If corrections or restatements were made to Ichi-co’s accounts, they weren’t material to Ichi-co’s parent and therefore didn’t require public disclosure.

And while Hashi-co and Ichi-co are suing each other for amounts each claims it’s due, the substance of the suits are confidential, because court filings – other than the initial complaints – aren’t publicly available in Japan. Unless Hashi-co wants to publicly accuse Ichi-co of fraud (and, therefore, draw attention to its role in the scheme), there’s little likelihood that Ichi-co and its parent will be associated with participating in a circular transaction scheme.

WARNING SIGNS 

Circular transaction schemes are often difficult to uncover without the assistance of an employee or an intermediary company engaged in the scheme because the documentation appears legitimate and cash actually changes hands. In Hashi-co’s case, the scheme was only uncovered when tight credit conditions prevailed in early 2009.

Moreover, U.S. headquarters failed to perform perfunctory checks on the information Mr. Sato reported. Following are a few of the risk factors and procedures that the IT parent company could have considered in evaluating Hashi-co’s performance in Japan:

Consider the influence of culture. There are often long-standing relationships among senior executives of trading partners in Japan. Understand who your employees are entertaining and why. Conversely, are your employees being entertained? Expense reports will provide insights into your employees’ key business relationships. Codes of conduct should set the company’s expectations regarding gifts from vendors. Clearly communicate these expectations to both your employees and your vendors.

Break down the language barrier. Don’t let the language barrier impede monitoring and oversight of your foreign subsidiaries’ activities. In the case of Hashi-co, Mr. Sato was the only employee who spoke English and, as a result, he was the sole point of contact for U.S. headquarters.

Consider retaining a local audit firm to serve as your eyes and ears on the ground and perform periodic reviews of expense reports or otherwise digging into numbers on your behalf. Also, when possible, visit the office and speak to staff.  

Know your customers, not just your distributors. Purchase orders from Ichi-go indicated that the end customers of Hashi-co’s products were household name companies, but the U.S. parent company never confirmed this information. A simple phone call could have revealed that the documentation was fictitious. Don’t rely on subsidiaries or intermediaries to tell you who your customers are.

Trust, but verify. Ensure that agreements with distributors and resellers contain audit clauses. In this case, if the U.S. headquarters had requested documentation of sales to Ichigo-co’s customers and performed a basic review, the documentation would have revealed that Ichigo-go wasn’t selling to the household-name companies it purported (per its purchase orders).

Small margins might indicate big problems. Are certain customers routinely given deals with lower-than-average margins? Does the volume of sales justify the difference? If not, there might be a risk that your company is an intermediary in a circular scheme. Intermediary parties frequently take a small margin for participating in the scheme, but it’s normally lower than their margins in their legitimate commercial transactions.

Look for vendors as customers, and vice versa. Circular transaction schemes often begin simply with two companies completing paper transactions at the end of a quarter to inflate each other’s revenues. As the scheme continues and grows, the perpetrators will later recruit other companies to act as intermediaries to disguise the flow of funds. As a result, the best opportunity to uncover a circular transaction scheme is early in its lifespan before layers of complexity are added.   
To that end:

1. Are there multiple distributors between you and your end customers?

2. What value or service does each layer of distribution provide?

3. Does your company have vendors that are also customers?

4. If so, does the balance of trade (purchases vs. sales) make sense?

5. Has the balance of trade changed over time, and do you understand the reason(s)?

6. How do margins for sales to this customer compare with sales to other customers?

7. Are there any unusual credits or offsets to the amounts due?

8. Are there any unusual transactions between your company and different business partners (i.e., a supplier with equal purchases and sales to an intermediary)?

9. Are there unusual personal interactions between the sales and purchasing functions related to this customer/vendor?

Because there are a number of issues related to managing such a relationship (in which a company serves as both a vendor and a customer), businesses should carefully design controls to reduce susceptibility to circular transactions.

Follow the money. How is cash applied? A quick review of Hashi-co’s cash receipts and accounts receivable showed that several large receipts of cash from Ichigo-co were broken up and applied to multiple customer accounts. And as is often the case in circular transaction schemes, Mr. Sato had been booking fictitious revenue. These fictitious receivables were cleared with funds received from other participants in the scheme (resulting in a lapping scheme with a twist).

NON-JAPANESE COMPANIES BEWARE 

As the second largest economy in the world, Japan represents a tremendous opportunity for many foreign companies. However, Japan’s unique business environment opens the door to a set of fraud considerations including circular transactions. Companies operating in Japan should take care to address these considerations and not allow language or cultural barriers to override effective controls and monitoring.

John R. Stanley is a director in PricewaterhouseCoopers’ Forensic Services Practices in Tokyo, Japan. 

Sofia Cramer is a senior associate at Herbert Smith law firm in Tokyo, Japan.   

The contents of this article represent the opinions, positions, and insights of the authors and don’t represent those of PricewaterhouseCoopers Co. Ltd. or Herbert Smith, their partners, and/or affiliated firms. The contents of this article don’t constitute accounting or legal advice and shouldn’t be relied on as such. Seek specific advice regarding your specific circumstances. 

The Association of Certified Fraud Examiners assumes sole copyright of any article published on www.Fraud-Magazine.com or ACFE.com. Permission of the publisher is required before an article can be copied or reproduced.  

Circular Transactions in the Japanese Media

The Japanese media has highlighted many police investigations and prosecutions of senior management of Japanese companies that allegedly artificially inflated their revenues via circular transactions.

One case in particular, which resulted in the recent conviction and seven-year prison term for the executive director of Japanese frozen food giant Katokichi Co. Ltd. for aggravated breach of trust and fraud, has been prominent in the media.

The executive director was accused of conspiring with the CEO of a Japanese trading company (who has since committed suicide) to orchestrate circular transactions resulting in a loss of nearly ¥5 billion (more than US$55 million) for Katokichi after the fraud was discovered. During closing statements, the defense team requested leniency, alleging that it was officially recognized throughout the company that circular transactions were being executed in response to the company’s policy of placing growth in sales above everything else. (Sources: “10 Years sought for former Executive Director/Katokichi, ‘Circular Transaction,’ “ Shikoku Shimbun, July 28, 2009, and “Sentenced 7 years in prison, a former Katokichi Executive Director for fraud/aggravated breach of trust,” Yomiuri Shimbun, Oct. 28, 2009)

Other prosecutions and investigations have concentrated on publicly listed companies and the fact that the artificially inflated revenues based on circular transactions resulted in false financial statements (a breach of Japanese securities laws, specifically the Financial Instruments and Exchange Law). (Source: “Window dressing: CEO of ‘Produce’ handed prison terms by the Saitama District Court,” Mainichi Shimbun, Aug. 5, 2009.)

The CEO of electronics manufacturer Produce Co. Ltd. was recently sentenced to three years imprisonment and a ¥10 million (approximately US$100,000) fine for violating the Securities Exchange Act (misstatement of a securities report). Between June 2005 and June 2007, during which time the company went public, the CEO conspired with various counterparties to inflate Produce’s sales by approximately ¥11.6 billion (approximately US$130 million) and create the impression of rapid sales growth. The judge commented that “this was an extremely atrocious crime that harms the fairness of the securities market.” (Source: Saitama District Court Judgment, Oct. 5, 2009)

Under any of the three standards, it’s easy to see how Mr. Sato’s circular transactions failed to meet the requirements to recognize revenue; in no case did physical delivery of product occur. As a result, Hashi-co was forced to restate its revenues for the current and prior three years under U.S. GAAP. The subsidiary also had to correct various other accounts related to the transactions including accounts receivable and inventory (because the “sold” product had been transferred off the balance sheet and stored in a secret warehouse).