Spiraling Out of Control

Fraudulent Japanese Circular Transactions Can Hurt Foreign Firms



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. (See Figure 1. All company names are fictitious and have no relation to any actual firms.)

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.

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