The TSE's Measures in Response to IPO Fraud
In response to recent cases of accounting fraud involving companies going public, the Tokyo Stock Exchange (TSE) and Japan Exchange Regulation (JPX-R) are introducing a new set of measures. The primary goal of these new rules is to enhance the quality of the listing examination process and prevent similar fraudulent activities from happening again.
This is a collaborative effort, involving not just the exchange but also other key stakeholders in the Initial Public Offering (IPO) process. These measures are designed to address specific vulnerabilities that can allow financial misconduct to go undetected. The core problem these rules aim to solve is the risk of companies presenting a false picture of their financial health to the public and investors.
1. The Key Players and Problems in an IPO
To understand the new rules, it is helpful to know the basics of how a company goes public and the risks involved.
1.1 What is an IPO?
An Initial Public Offering (IPO) is the process through which a private company becomes a publicly-traded company. It does this by selling shares of its stock to the public for the first time, allowing it to be listed and traded on a stock exchange like the TSE.
1.2 Understanding the Risk: 'Round-Tripping'
One of the key types of fraud the new rules target is known as "round-tripping." In simple terms, this is a deceptive practice where a company sells its products to another party and then secretly arranges for those same products to be bought back, often through a series of intermediaries. This scheme makes it look like the company is generating real sales and revenue when, in reality, no genuine business has occurred. The goal is to artificially inflate the company's financial performance to look more attractive to investors.
1.3 Who are the Gatekeepers?
During an IPO, several key organizations act as "gatekeepers" to ensure the company is legitimate and its financial information is accurate. The new rules place a greater focus on the responsibilities of these players:
- Lead Underwriters: These are securities companies (like investment banks) that act as the primary managers of the IPO process. They help the company prepare its documents, determine the share price, and sell the shares to the public. Their job is to perform due diligence and examine the company thoroughly.
- Auditing Firms: These are independent accounting firms responsible for auditing, or officially inspecting, a company's financial statements. Their role is to verify that the company's financial records are accurate and comply with accounting standards, providing a credible check on its reported performance.
These gatekeepers are the first line of defense against fraud, which is why the TSE is now implementing specific measures to strengthen their oversight and accountability.
2. A Closer Look at the New Measures
The exchange is taking several concrete steps to make the IPO process more secure and transparent. These actions can be grouped into three main areas.
2.1. Stricter Scrutiny Before Listing
The exchange will conduct a more rigorous, risk-based examination of companies applying to go public. Key actions include:
- Investigating Business Models: For companies that rely heavily on agents or intermediaries for their sales, the exchange will now confirm the identity of the "substantive" (real) suppliers and customers.
- Benefit: This directly combats round-tripping by ensuring that sales transactions are legitimate and not just part of a circular scheme.
- Questioning Key Changes: If a company suddenly changes its auditing firm, lead underwriter, or even the key personnel at those firms during IPO preparation, the exchange will investigate the reasons why. This process is taken very seriously, involving steps like requesting the company to waive confidentiality obligations so the exchange can conduct a confidential interview with the predecessor firm, the contents of which are not disclosed to the applicant company.
- Benefit: This helps uncover potential "red flags," such as a company pushing out an auditor or banker who was asking too many tough questions about its finances.
- Requiring More Information: Companies must now include an overview of their major real suppliers and customers in their official listing application documents.
- Benefit: This directly addresses the "round-tripping" risk by forcing transparency on who the company is actually doing business with, making it harder to hide fraudulent schemes.
2.2. Strengthening Internal Controls and Information Sharing
The new rules also focus on creating better systems for reporting and sharing information about potential misconduct.
- Better Whistleblowing Systems: Companies preparing for an IPO must prove they have an effective whistleblowing system. This includes having reporting channels that are independent of top management, which is critical to prevent executives from burying complaints made against themselves. The system must also include clear internal rules for ensuring the confidentiality of whistleblowers, prohibiting disadvantageous treatment, and measures to prevent reported information from being communicated to wrongdoers.
- Promoting the Exchange's Hotline: The exchange will actively promote its own "information contact desk." This ensures that employees at companies preparing to list know they have a direct and confidential channel to report concerns about misconduct. Crucially, the exchange will also establish procedures to ensure that this information can be easily and securely shared with the company's lead underwriter and auditing firm, creating a connected loop of oversight.
2.3. Focusing on Executive Integrity
The exchange is placing more responsibility on the integrity and oversight of company leaders. This involves examining both the systems in place and the people overseeing them. First, the exchange will strengthen awareness activities for executives, emphasizing the "responsibility of being a listed company" to reinforce a culture of integrity.
Furthermore, during the listing examination, the exchange will conduct interviews with a company's outside directors and auditors to confirm their assessment of the fraud prevention systems. It will also investigate the circumstances of their appointment to identify any potential vulnerabilities—for example, if a director was appointed due to a close personal relationship with a CEO, which might compromise their independence.
3. A Team Effort to Protect the Market
The Tokyo Stock Exchange recognizes that it cannot solve this problem alone. Preventing fraud requires a coordinated effort because the gatekeepers—underwriters, auditors, and the exchange itself—are part of an interconnected system. A failure in one part compromises the whole. Therefore, the TSE is partnering with other key organizations to strengthen the entire IPO ecosystem.
This multi-faceted approach ensures that all parties are aligned in their mission to uphold market integrity.
4. Conclusion: A Balanced Approach to a Safer Market
The central purpose of these new measures is to prevent accounting fraud and increase the reliability and trustworthiness of companies listing on the Tokyo Stock Exchange. By tightening scrutiny, improving information channels, and fostering collaboration, the exchange aims to protect investors and maintain a healthy market.
Importantly, the exchange intends to implement these rules in a balanced way. The goal is to avoid placing "excessive burdens on companies preparing for listing," particularly startups. Measures will be tailored to a company's specific level of fraud risk. This thoughtful approach aims to create a more trustworthy and secure market for everyone—investors and innovative companies alike.
Norbert Gehrke
