Murakami Fund Judgment

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2007. 07.27

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Please click here for Japanese version, "村上ファンド判決速報."

By Yaeko Hodaka

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

Evaluation of the Judgment

On July 20, 2007, the Tokyo District Court handed down a judgment in the Nippon Broadcasting Inc. insider trading case, sentencing the defendant Yoshiaki Murakami to two years imprisonment, and a fine of 3 million yen, and a surcharge of almost 1.5 billion yen. MAC Asset Management Inc. was also fined 3 million yen.

Most of the reaction to this judgment was negative, at least initially. The reasons for this included the fact that, in failing to consider the likelihood of whether the material items of information ("material facts") that were the basis for a determination that "insider information" was involved would in fact be materialized, the judgment deviated from a 1999 Supreme Court judgment1 , and that the threshold for determination of criminal liability had been lowered unreasonably.

However, examining the reasoning of the decision in detail, it is suggested that it should in fact be viewed as consistent with prior precedent and existing practice, and that it merely serves as confirmation of such. Neither does it seem that the court has unreasonably relaxed the requirements regarding decisions on material facts, etc. In fact, the significance of this judgment lies in the guidance it gives to "activist" investment funds.

This article examines the court's reasoning, and focuses on the central issue of "decisions regarding tender offers, etc".

When should a "decision" be deemed to have been made?

In the present case, the issue was violation of Article 167 of the Securities and Exchange Law (the "Law"), which concerns prohibited acts of bidders and associated persons. Under this article, two elements are required to constitute a prohibited act: there must be trading of shares with the knowledge that (1) a bidder (Livedoor in the present case) has (2) made a "decision" to carry out a tender offer, etc. (including acts equivalent to a tender offer, i.e. acts such as purchasing shares are included2 ), before that knowledge has been made public. The particular issue in the present case was element (2)3 . The text of the Law deliberately specifies a "decision regarding carrying out a tender offer, etc." rather than a "decision to carry out a tender offer." Thus the form of the provision is clearly differentiated from that of a provision concerning withdrawal of a tender offer which reads "a decision not to carry out a tender offer, etc." The provisions regarding decisions on material facts in Article 166, Paragraph 2, items 1 and 5 similarly contrast a "decision regarding carrying out," in the case of implementation, and a "decision not to carry out" in the case of termination. The generally given reason for this distinction is the fact that such a decision to implement not only includes a decision on the matter concerned, but also decisions on carrying out various tasks in the process leading up to the matter concerned, including investigations, preparation, and negotiation ("preparatory acts"). The reasoning is that, once such a decision is made, it is already possible for the investment decisions of investors to be affected, and thus it is necessary to include decisions to carry out preparatory acts in the definition of "decision." This interpretation is commonly accepted. This was made clear in the abovementioned Supreme Court judgment, which said that the "decision" "means the decision to actually issue shares as well as a decision that tasks leading up to such issue of shares would be carried out in the course of the company's business." On this point, the present judgment does not take a new approach, sticking to the existing approach by saying that the "decision" "means the decision to actually carry out a tender offer as well as a decision that tasks leading up to such tender offer would be carried out in the course of the company's business."

In considering element (2), the present judgment focused mostly on whether there is a requirement for an objectively high probability that the matter decided will actually occur in order to deem that a "decision" has been made. Regarding this point, the abovementioned Supreme Court judgment stated that "the appropriate interpretation is that, it is necessary that [the operational decision-making body] intended at the time that [the matter decided, i.e., the issue of shares] would actually occur, but there is no requirement that there was an expectation that the issue of the shares concerned was certain." In contrast to this, after citing the Supreme Court judgment, the present judgment states, "That is, the interpretation is that, although cases where there is absolutely no probability of actual occurrence are excluded, it is sufficient that there is some probability, and the degree of that probability is not an issue." This part of the court's reasoning has been criticized in some quarters for inappropriately lowering the hurdle even further than the Supreme Court, which even recognized as material facts information the materialization of which was not certain.4

However, in the case of a decision to purchase shares, a decision to carry out preparatory acts in the course of business means that the preparatory acts themselves are a prerequisite for purchasing shares. Conversely, there will obviously be cases which result with no purchase of shares being carried out because of the result of those preparatory acts. It is generally accepted that, at the time such preparatory acts are commenced, it is not possible to ascertain whether or not there is a high probability that the decided matter (i.e., the share purchase) will occur. Therefore, if a decision to carry out preparatory acts is deemed sufficient to constitute a "decision" for the purposes of the Law, it could be said that it is only natural that the degree of probability that the decided matter that results from those preparatory acts (the act of buying shares) will actually occur is not relevant.

The abovementioned Supreme Court judgment merely states that "there is no requirement that there was an expectation that the issue of the shares concerned was certain." Interpreted straightforwardly, this is simply saying that it is not a requirement that there be a probability of occurrence. So, if one is forced to look for a point on which the present judgment departs from that of the Supreme Court, it can be said that it is actually in the fact that, by stating that "cases where there is absolutely no probability of actual occurrence are excluded," the scope of cases where a "decision" is deemed to have been made has been limited.

Practically, there will be extremely few cases where an operational decision-making body intends that specific shares are to be purchased, and decides to carry out preparatory acts to that end in the course of the company's business, but at the same time the probability that the shares will actually be purchased is zero, or exceedingly low. This in turn means that, even if a decision were made to carry out preparatory acts for purchasing shares despite it being clear that there was no probability, or an exceedingly low probability, that such purchase would actually occur, it would be doubtful that, at the time of making the decision, the operational decision-making body intended the matter to actually occur, leading to the conclusion that a "decision" cannot be said to have been made for the purposes of the Law.

As described above, the current judgment does not particularly deviate from the approach of prior precedent and existing practice, but rather remains within those boundaries, and it should not be seen as having relaxed the requirements for determining whether a transaction is an insider transaction.

Operation of "Activist" Investment Funds

In reference to the operating circumstances of the so-called Murakami Fund, the present judgment states that "despite splitting into separate companies on being advised by auditors that it was appropriate to conduct activist operations and investment advisory business separately, the actual circumstances were such that the defendant exercised overall control, and as one individual acted as both an activist and a fund manager. It is possible to point to this operating structure itself as having brought about this case. It can certainly be said that the insider trading at issue in this case is a crime that stemmed from structural deficiencies in the organization of the Murakami Fund. As such, the criminal act in this case was not a matter of chance, but was inevitable."

It can naturally be anticipated that investment funds and similar organizations will actively give recommendations to investee companies on the implementation of their business5 . In the course of giving such recommendations to companies' management, it is possible that they will become aware of material facts subject to insider trading regulations. At the same time, if a fund ends up in a situation where it is prevented from selling in an appropriate manner the shares it holds based on an assessment of market trends, then it will be difficult to operate the fund properly. For this reason, the need to have fire walls in place between the division responsible for investment decisions and the division involved in activism has been emphasized. The present case takes this further, stating that, without such a structure, insider trading is "inevitable." The significance of this decision therefore lies in this point, as it clarifies the courts' thinking regarding operation of investment funds.6

Decision of the Supreme Court of June 10, 1999 in the Nippon Orimono Kako insider trading case. The issue in this case was the use of insider information concerning the issue of shares (Securities and Exchange Law Article 166), and thus the applicable provision differs from that of the present case in which the issue was the use of insider information in a tender offer or purchasing of shares equivalent to a tender offer (Article 167). However, the interpretation of the provisions regarding the required elements is essentially the same.
"Tender offer, etc." includes a tender offer for shares of another company, a tender offer by a company for its own shares, and purchasing of share certificates with voting rights of 5% or more (regardless of whether in the market or through negotiation).
Regarding requirement (1), Article 167, Paragraph 2 of the Law provides that, if the bidder, etc. is a corporation, a "decision" is deemed to have been made when there is a decision by the operational decision-making body of the corporation. Because the investment decisions of investors can be affected by a decision that is seen to be effectively a decision of the company, even if it was not made by a body with decision-making authority as defined by the Corporation Law (e.g. general meeting of shareholders, board of directors), the Supreme Court decision of June 10, 1999, states regarding such a decision making body that "it is not limited to those bodies set out in the Commercial Code. It is sufficient that it be a body that can make decisions that effectively amount to decisions of the company." This interpretation of the provisions was affirmed in the present case. Specifically, the decision making body of Livedoor was recognized as comprising the President & CEO Takafumi Horie and Chief Financial Officer Ryoji Miyauchi, who were ultimately in charge of corporate takeovers. The decision relevant to the present case was made by the two men unanimously, and this was deemed sufficient to amount to a "decision" for the purposes of the Law.
Despite deeming that the degree of probability of actual occurrence was not an issue in determining criminal liability, the probability of actual occurrence was considered, as it was seen as important information for sentencing. According to the judgment, the probability that the purchase of large amounts of Nippon Broadcasting shares as decided would actually occur was--in light of Livedoor actually having the resources needed to purchase 5% of the shares, its financial situation, fund raising capability, and the fact that it actually did purchase large amounts of shares--"considerably high."
In fact, if a fund acquired a large volume of shares without making any such recommendations, there is a risk it would be labeled a greenmailer simply aiming to make a quick profit.
An individual offender who violates the provisions on prohibited acts in Article 167, Paragraph 1 of the Law may be penalized by up to 5 years imprisonment, a fine of up to 3 million yen, or both, according to item 13 of Article 197-2. Also, Article 207, which deals with dual liability of the corporation to which the individual offender belongs, provides that, if a representative or employee or any other worker of a corporation commits an offence related to the business of the corporation, then in addition to penalizing the individual offender, a fine may also be imposed on the corporation. That is, a corporation can only be penalized if a crime has been committed at the individual offender level. This means that, for example, in a case where Employee A and Employee B belong to the division responsible for activist operations and the investment management division of Company X, respectively, and where a fire wall is in place between the divisions to prevent passing of information, if Employee B carries out investment management using independent judgment, not being aware of material facts, etc. that Employee A has obtained regarding an investee company, then no crime is committed by either employee and thus there can be no crime on the part of Company X itself.