Takafumi Horie, the thirty-three-year-old CEO of Livedoor, had become Japan's anti-establishment enfant terrible: rich, hard charging, willing to take big risks such as the ultimately failed attempt to acquire a controlling interest in Nippon Broadcasting Systems. While many traditionalists thought Horie represented all that is wrong with Western-style capitalism, others saw him as the future of the country's media industry, and a man of the people.
But last month, Horie was arrested on suspicion of accounting fraud and illegal securities trading. When investigators raided Livedoor's offices, panic selling caused an unprecedented early shutdown of the Tokyo Stock Exchange. Horie, who denies wrongdoing, was arrested on January 23.
What went wrong at Livedoor, and what are we to learn from its undoing? Robin Greenwood, an assistant professor in the Finance Unit at Harvard Business School, has researched stock price manipulation in Japan and looked specifically at firms like Livedoor. He says the Livedoor episode may, in the end, do some good by paving the road for reform of Japan's "abysmal" corporate governance.
Sean Silverthorne: Could you tell us about your research into market manipulation, especially in Japan?
Robin Greenwood: Generally speaking, market manipulation comes in two forms: manipulating investor expectations, or manipulating investors' ability to trade. Financial economists know a lot more about the former than the latter.
Unusually in Japan, manipulating investors' ability to trade was an important aspect of price manipulation for many firms over the past few years. My research looks at how firms used stock splits to manipulate the float—the fraction of shares available to trade—in an effort to keep stock prices high. Livedoor was the most prominent abuser of stock splits, and we are now seeing the results. The market is jittery because it worries that there are more firms like Livedoor waiting to be exposed.
Q: Between 2003 and 2004, Livedoor split its stock three times, once in a ratio of 100-for-1. An investor who owned one share in early 2003 would have 10,000 shares today. Why would a company want to cut the trading price of its stock by so much?
A: In a stock split, each share of the firm is divided into more units, but the proportional ownership of each shareholder stays the same. In the U.S., firms split to keep their price in a relatively narrow trading band, say between $20 and $50. In a typical year, about 300 firms split their shares, and most splits are in ratios of 2-for-1 or 3-for-2. There are some famous examples of firms that have decided not to split, like Berkshire Hathaway and recently Google, but these are rare.
In Japan, things were very different. If you were to look at stock prices at the end of 2000, you would have found many stocks with prices over $10,000. Many of these firms had never split, even once. Because stocks were expensive, individual investors could not, for the most part, participate in the equity markets unless they had a lot of money. In 2001, however, a law requiring net assets per share to remain above 50,000 yen was repealed, clearing the way for firms to split to lower prices, and thus attract retail investors.
When a stock split occurs in Japan, the new shares are not distributed for several months. During this time, investors can buy or sell their "old" shares, but are unable to sell the shares they are about to receive. For example, if the stock splits 2-for-1, an investor who owns one share will hold on to the old share during the split but will not receive the new share for several months, at which point he can sell it. This system is the result of ownership being tracked on paper rather than electronically—it takes time to print out new share certificates. Because investors do not have access to the new shares, a significant fraction of the firm cannot trade. When investors cannot sell, prices rise.
Livedoor understood that once it decided to do a stock split, there was no reason to stop at 2-for-1. In December 2003, they announced a 100-for-1 split. At the time of the announcement, Livedoor had a price of around ¥156,000. Following the split, an owner of one share of Livedoor retained his one share worth only ¥1560 and received a claim to receive in two months ninety-nine more shares of the same value. Thus in a firm that was worth over $1 billion, investors only had access to $10 million to trade. From the date that Livedoor announced the split, the price rose nearly tenfold.
With the stock split came an increase in publicity, which helped maintain capital inflows from individual investors. The media has drawn a lot of attention to Horie's boyish antics—he is a regular guest on national talk shows and drives a Ferrari around the streets of Tokyo—but I suspect that this was all part of a plan to maintain investor interest in his stock. Livedoor had more than 200,000 shareholders, mostly individuals. This is an incredible number.
Together with Livedoor, hundreds of firms around Japan have announced stock splits over the past few years, often with gigantic increases in price. These events became so widespread that they earned the name "stock split bubble."
Q: So Livedoor was part of a greater phenomenon?
A: Absolutely. Between 2003 and 2004, over 400 firms split their shares. This number can be compared with only thirty-four firms that announced stock splits between 1995 and 1998! My research shows that on average, firms that executed stock splits during this time went up by over 30 percent more than the market. About half of these returns were reversed when the new shares were distributed to investors, consistent with investors trying to sell as soon as possible. Many of these firms have come down further in price, but there will probably be more. Regulators have recently put into place safeguards that will prevent high-ratio stock splits in the future.
If anything, Livedoor was the cleverest of the stock splitters, as it recognized that a high post-split stock price would allow the firm to complete stock financed acquisitions. As long as investors in the target company were willing to accept overpriced Livedoor stock as a form of payment, Livedoor could keep gobbling up other firms. Over the past few years, Livedoor acquired more than twenty companies, most paid for with stock. Livedoor's most famous transaction, its failed attempt to buy Nippon Broadcasting Systems last year, was financed with convertible debt. However, the debt was converted into equity almost immediately, making that, too, an essentially stock-financed transaction.
Many of Livedoor's acquisitions were great companies, and continued to perform well under the Livedoor brand. This probably explains why the pyramid scheme did not come tumbling down much earlier. However, it now appears that some of the acquisitions were used to shield Livedoor losses.
Q: Does this behavior teach us anything about financial markets?
A: At first glance, Livedoor appears to be like many firms in markets around the world, which have used a high stock price to foster equity financed growth. But I think there are broader lessons in the specific way that stock splits helped maintain high prices. While the institutional irregularity is unusual to Japan, a more general principle that emerges is that firms will try to restrict their investors from trading. A researcher at Yale recently showed that many firms try to discourage short-sellers of their stock by launching ad campaigns threatening to them. Not surprisingly, this behavior seems to work. A more benign form of this occurs when firms spend resources to attract a particular kind of investor. Institutional investors, for example, are thought to be attractive holders for your stock because they do not trade much.
Getting back to Japan, the stock splits can be thought of a form of float manipulation. By limiting the number of shares on the market, and making it difficult to sell, prices can only go up. A similar mechanism occurs in initial public offerings, where the supply of shares offered to the public is very small. Because only optimistic investors buy, and it is difficult for others to go short, many IPOs end up being overpriced.
Q: What do you think Livedoor's legacy will be?
A: It is possible that Livedoor will be remembered as just a fraud. And to some extent, this is well deserved. However, I think Horie deserves some credit. Although he may not have been good at operations, he had a deep understanding of financial markets and a perception of what investors wanted to hear. In some sense, he figured out that selling stock to investors was much easier than selling product to customers. But more importantly, he revitalized Japan's sleepy market for corporate control. In the attempt to acquire Nippon Broadcasting Systems, Livedoor drew attention to the cronyism that governs Japan's corporate world.
I worry that members of Japan's old guard will use the Livedoor event try to rationalize anti-takeover defenses. Their argument might be that the next time a firm tries to take them over, it is only using overpriced equity and hence is bad for target shareholders. But this would take Japan in the wrong direction. Corporate governance in Japan is abysmal—most firms are run in spite of, rather than for, their shareholders. And a world in which the managers are making investment decisions for the shareholders is a scary one. If investors want to overpay, they have only themselves to blame. Let the markets work it out.