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ICMR Center for Management Research

Sumitomo Corporation of Japan:

The Commodity Derivatives Fiasco

This case was written by Gautam O, under the direction of Gupta V, ICMR Center for

Management Research (ICMR). It was compiled from published sources, and is intended to be

used as a basis for class discussion rather than to illustrate either effective or ineffective handling

of a management situation.

2004, ICMR Center for Management Research

ICMR, Plot # 49, Nagarjuna Hills, Hyderabad 500 082, India

Email: info@icmrindia.org.

www.icmrindia.org

2

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Sumitomo Corporation of Japan:

The Commodity Derivatives Fiasco

“At fault may be a global business culture that lavishly rewards traders who take risks but not the

people who are supposed to supervise them.”1

- David Hale, Economist, Zurich Kemper Investments.

“The moral fiber of all Japanese has deteriorated and they have become desensitized toward

money.”2

- Seiroku Kajiyama, Chief Cabinet Secretary, Japan.

INTRODUCTION

On June 13, 1996, Sumitomo Corporation (Sumitomo)3 – one of the largest trading companies in

Japan, reported a loss of $1.8 billion (bn) in copper trading on the London Metal Exchange

(LME)4. The loss was the result of trading operations in commodity derivatives by Yasuo

Hamanaka (Hamanaka), Sumitomo‟s former chief copper trader. Elaborating on the reasons for the

loss incurred by the company, Tomiichi Akiyama (Akiyama), the then president of Sumitomo said,

“These transactions were made solely by Yasuo Hamanaka himself. Hamanaka abused

Sumitomo‟s name, and continued on with such unauthorized trading.”5

Sumitomo was the largest participant in the physical market6 for copper, its volume being twice

that of the second largest participant. The loss reported by Sumitomo was the largest unauthorized

trading-related loss incurred by any Japanese company during that time. This financial debacle

occurred at a time when the world‟s financial markets were yet to recover from two major

financial debacles – the collapse of UK‟s 233-year-old Barings Bank, which lost $ 1.4 bn in

February 1995 due to Nick Leeson‟s unauthorized trading activities in the Singapore futures

market and the Japanese bank Daiwa which lost $1.1 bn in America‟s Treasury bond market in

September 1995 due to the unauthorized trading activities of Toshihide Iguchi, a New York based

trader. All the three debacles happened within a short span of 16 months.

Industry analysts and the media were quick to comment that the trading in commodities and financial instruments was not being properly monitored by the government regulatory agencies and by the companies undertaking these transactions. Ota Rie of ING Barings in Tokyo said, “What

1 „The Copper Debacle,‟ Egan, Jack, US News & World Report, July 1, 1996. 2 „The Mighty Copper King,‟ Levinson, Marc and Bartholet, Jeffrey, Newsweek, June 24, 1996. 3 Apart from trading in all commodities worldwide, Sumitomo also provided various financial services,

organized and coordinated various projects and invested in businesses ranging from IT to retailing

industry. 4 The London Metal Exchange (LME) with a turnover of US $2,000 bn per annum is the world‟s premier

non-ferrous metals market. 5 „Sumitomo Losses Mount,‟ Dorman Bill, www.money.cnn.com, September 19, 1996. 6 Commodities market in which goods are sold for cash and delivered immediately is known as physical

market. It is also referred to as spot or cash market.

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Sumitomo did with this man was very unusual. It is rare to see a middle-level manager get so much power.”7 Experts said that the situation demanded tighter internal supervision and control procedures by trading firms and financial institutions the world over. Kenichi Yoshida, an analyst at Nikko Research Centre said, “Hamanaka was famous because of the business he brought in. He was given a great deal of responsibility by the company, and his only regulators were overseas, far from Tokyo.”8

In September 1996, Sumitomo disclosed that the company‟s financial losses resulting from copper trading were much higher than $1.8 bn. The revised loss figure of $2.6 bn represented about ten per cent of Sumitomo‟s annual sales. In order to control mounting losses, Sumitomo began aggressive liquidation of its uncovered positions in the copper physical and futures market under its new president Kenji Miyahara. Sumitomo also cancelled its plans to buyback 20 mn of its shares and award Yen 120 mn ($1.1 mn) of bonuses to its senior managers. However, analysts believed that these measures would hardly make up for the damage that had already been done.

BACKGROUND NOTE

Sumitomo was initially established as Osaka Hokko Kaisha Limited in December 1919 with a capital of 35 mn yen. The company entered into the trading business in 1945 with a new name „Nihon Kensetsu Sangyo Kaisha Limited.‟ In 1949, the company got listed on the Osaka, Tokyo and Nagoya stock exchanges. In 1952, it changed its name again to „Sumitomo Shoji Kaisha Limited.‟ By 1962, the company had nine business divisions – Iron & Steel, Nonferrous Metals, Electric, Machinery, Produce & Fertilizer, Chemicals, Textile, General Products & Fuel and Real Estate. In 1973, it got listed on the Frankfurt Stock exchange and in 1978 it adopted the name „Sumitomo Corporation.‟ Sumitomo consisted of six corporate groups, nine business units and twenty-eight business divisions (Refer Exhibit I & II for History of Sumitomo and its Organization Chart).

Hamanaka was a law graduate from Seikei University9. He had joined Sumitomo in 1970. In 1975, the company assigned Hamanaka to the copper section of the non-ferrous metals division. In the late 1970s, he was sent to London for a short period to learn the London Metal Exchange business by working as a clerk in a tin and nickel company. On his return to Japan, Hamanaka preferred to remain in the copper section of Sumitomo‟s non-ferrous metals division.

Hamanaka‟s excellent performance enabled him to rise steadily above the ranks in the copper section. By 1983, Hamanaka was selling around 10,000 tonnes of copper annually. He succeeded in gaining the confidence of Saburo Shimizu (Shimizu), the head of the copper trading team. In order to sustain the copper section‟s profitability, Hamanaka and Shimizu began to make unauthorized speculative copper commodity futures transactions in 1984. However, they were not successful in their trading activities and incurred huge losses. To conceal these losses from the top management, the duo entered into off-the-books deals. By 1987, the losses rose to about US $58 mn. With the losses rising significantly, Shimizu decided to quit and Hamanaka was appointed head of the copper trading team.

EVENTS LEADING TO THE DEBACLE

On taking charge of the copper trading team, Hamanaka tried to recover the losses by taking huge positions in copper commodity futures on the London Metal Exchange. The huge volume of trading attracted the attention of the exchange and it gave a warning to Hamanaka. Hamanaka then struck a deal with Merrill Lynch10 for US $150 mn, which enabled him to trade via Merrill at

7 „Sumitomo‟s Shokku,‟ Fletcher, Matthew and Shameen, Asif, www.asiaweek.com, June 28, 1996. 8 „Billion Dollar Loser,‟ Serrill, Michael E., Time International, June 24, 1996. 9 Established in 1949, Seikei University is a private, co-educational university and is a part of the Seikei Gakuen

family of schools, consisting of an elementary school, a junior high school, a high school and the University. 10 Merrill Lynch is one of the world‟s leading financial management and advisory companies, with offices

in 35 countries and private client assets of approximately $1.1 trillion.

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LME. Hamanaka borrowed money from several banks without any authorization from his seniors. He used the funds either to buy copper or pay for the collateral that he was required to deposit at the LME to cover loss-making positions.

By 1990, Hamanaka was reporting huge trading profits to the top management by showing

invoices of fictitious option trades, which he had created through a nexus with some brokers. By

reporting huge profits on a regular basis, Hamanaka was able to achieve the status of „star trader‟

at Sumitomo. Hamanaka got the nickname „Mr. 5%,‟ that reflected the share of the world copper

market that he controlled on behalf of Sumitomo. The company‟s management was proud of his

achievements in the world copper markets and even featured his photo on the cover of one of its

annual reports. Hamanaka was given more autonomy and his trading positions were funded by the

amount, which he borrowed by pledging Sumitomo‟s copper stocks.

In 1991, David Threlkeld, a metal broker in London received a request from Hamanaka to issue a

backdated invoice worth about US $350 mn for non-existent trades. Threlkeld lodged a complaint

against Hamanaka with LME. LME informed Sumitomo about this matter. However, subsequent

investigations by Sumitomo found no evidence against Hamanaka. The company dismissed the

matter saying that Hamanaka required the invoice for tax reasons.

In 1993, copper prices plunged and Hamanaka‟s trading losses began to increase significantly.

Hamanaka started dealing through Credit Lyonnais Rouse11 and also forged the signatures of his

senior managers to borrow US $100 mn from the ING Bank12. Sumitomo held an internal

investigation into this incident but did not take any action against Hamanaka.

In order to raise more funds and cover the losses, Hamanaka entered into a series of unauthorized

transactions. He sold put options13 to Morgan Guaranty Trust14 whereby he lost $393 mn. A further

unauthorized sale of puts and calls via Morgan to raise $150 mn resulted in a loss of $253 mn in

1994. To cover the loss, Sumitomo Hong Kong borrowed $350 mn from seven banks (including

Sumitomo Bank). Hamanaka paid off Morgan through a further borrowing of $420 mn.

In 1994, an inquiry was conducted by the Securities and Futures Authority (SFA)15 into the

relations between Sumitomo and UK-based trader Winchester16, which conducted commodity

transactions for a Chile-based copper mining company Codelco.17 The SFA found that Winchester

had made significant money by working as a broker for Sumitomo. The SFA reported this matter

to Sumitomo and asked the company to furnish details about Hamanaka‟s trading activities.

11 Credit Lyonnais Rouse is a leading financial services company having its presence in over 50 countries.

Its three main business lines are retail banking, investment and corporate banking and asset management. 12 ING Bank is part of the Netherlands-based ING Group, one of the world‟s largest banking and financial

services companies. It operates in over 60 countries and has over 115,000 employees. 13 An option contract is said to be a „put option,‟ if the writer or seller of the option gives the buyer the right

to sell an underlying asset at a specific price which is agreed upon at the time of entering into the

contract. 14 Morgan Guaranty Trust is a principal subsidiary of JP Morgan & Company. It was formed in the year

1959 by the merging merger of public corporation Morgan and Guaranty Trust Company, a New York-

based commercial bank. 15 The Securities and Futures Authority (SFA) is an independent non-government regulatory body in the

UK. The main objective of this regulatory body is to maintain confidence in the financial system, create

public awareness, and work for consumer protection and reduction of financial crime. 16 Winchester Commodities Group Ltd was a UK-based trading company established in the early 1990s. In

March 1998, the company decided to wind up its business in view of investigation of its role in various

commodity scandals, the major one being Sumitomo. 17 Corporacion Nacional Del Cobre (Codelco) is the Chile‟s state-owned copper mining, ore processing and

metals marketing company. With over 60 years of experience in the mining arena, Codelco produces

approximately 1.5 mn tonnes of fine copper annually and has copper reserves that constitute

approximately 20% of the world‟s identified copper reserves.

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During the period October to December 1995, Hamanaka in collaboration with another firm Global Minerals and Metals Corporation, took huge positions in copper spot and futures market which helped him acquire a controlling position in LME‟s warehouse stocks of copper. By hoarding copper in warehouses, Hamanaka ensured that a large percentage of copper supply was out of the market. This created an artificial shortage of copper and caused the price of copper and copper futures to shoot up. (Refer Exhibit III). When the prices flared up, Hamanaka earned profits by selling a part of the futures contract.

The unusually high fluctuations in copper prices forced the US Commodities Futures Trading Commission (CFTC)18 and the Securities Investment Board (SIB)19 in Britain to launch an investigation. Sumitomo was asked to cooperate and provide all the materials required for investigation.

The emergence of „backwardation,‟ a situation in which copper for immediate delivery cost more than the copper to be delivered two or three months later, drew the attention of the CFTC. In the derivatives market, backwardation was not rare but if the condition persisted over a period of time, it could mean that a trader was illegally controlling a large share of the commodity and was artificially increasing the price (Refer Exhibit IV).

In March 1996, while reconciling a bank statement from a foreign bank with the records in the Treasury Department, Sumitomo discovered that the bank had credited the company with funds from an unknown transaction. The accounts department of Sumitomo started investigating into Hamanaka‟s trading. As a result of the inquiries initiated in November 1995 by the LME, SIB and CFTC, Hamanaka was relieved of his day-to-day trading duties in early May 1996. In June 1996, Hamanaka confessed his involvement in unauthorized commodity derivatives trading and forgery.

WHY DID IT HAPPEN?

Analysts felt that the debacle was the result of Sumitomo‟s poor managerial, financial and operational control systems. Due to this, Hamanaka was able to carry on unauthorized trading activities undetected by the top management. The vesting of excessive decision power on a single employee and failure to implement the job rotation policy were the other reasons cited.

LACK OF SUPERVISION/INVOLVEMENT OF SENIOR MANAGEMENT

There was a lack of effective monitoring and supervision of Hamanaka‟s trading activities. Hamanaka was believed to be an expert in risk management and had a star trader status at Sumitomo. By entering into fictitious trades and manipulating accounts, Hamanaka successfully misled the management to believe that he was making huge profits. Since Japan was going through a recession, the top management was very happy with the extraordinary trading profits shown by Hamanaka and never made efforts to investigate the high risks, which were associated with the trading activities. Moreover, the frequent changes and Hamanaka‟s previous superiors leaving Sumitomo also contributed towards the lack of effective supervision over Hamanaka‟s activities.

Hamanaka‟s unauthorized trading activities were brought to Sumitomo‟s notice more than once by foreign regulatory authorities. A little vigilance on the part of senior management would have enabled detection of Hamanaka‟s unauthorized trades and falsification of accounts. Sumitomo also seemed to have relaxed its policy of rotation of posts. Hamanaka was allowed to continue in the copper division during his entire tenure with Sumitomo.

18 CFTC was created as an independent agency by the US Congress in 1974 under the authorization of the

Commodity Exchange Act with the mandate to regulate commodity futures and options markets in the

US. The CFTC was responsible for overseeing the economic utility of futures market by encouraging

their competitiveness, efficiency and integrity and by protecting market participants against

manipulation, abusive trade practices and fraud. 19 The SIB is the regulatory agency responsible for regulating the securities & derivatives market in the UK.

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PROPER CONTROL PROCEDURES

Analysts said that Japan‟s „ethic of corporate loyalty‟, which assumed that no employee would

indulge in unauthorized activities was one of the main reasons for lesser control and supervision of

employees in Japan. Hamanaka was given a lot of autonomy to trade in copper. This enabled him

to make huge unauthorized borrowings from financial firms like Merrill Lynch to capture and

control a large part of copper market on the LME. When the scam first came to light, Hamanaka

was believed to have accumulated about 4,00,000 tonnes of copper with an objective of

manipulating its prices. Lack of adequate control allowed Hamanaka to take money in advance,

forging signatures of senior managers. Hamanaka was also able to falsify company records without

being detected. Analysts said that the fact that Hamanaka was able to conceal his trading losses for

nearly ten years showed that there was a major fault in Sumitomo‟s internal auditing procedures.

LACK OF PROPER VIGILANCE

The lack of proper vigilance and action on the part of regulatory authorities enabled Hamanaka to

control and manipulate copper prices on LME. This debacle also brought to the fore LME‟s

inability to efficiently supervise and audit trading activities. LME officials denied any failure on

their part and claimed that Sumitomo was not an LME member and that it traded through brokers.

They squarely blamed Hamanaka‟s large over the counter (OTC) trading activities for the debacle.

LME further claimed that in 1991 and 1993, it had passed on information about doubtful dealings

of Sumitomo to the appropriate regulators. However, analysts said that the question still remained

as to why Sumitomo‟s huge position in the overall copper market was not investigated upon by the

LME. The copper market cornering by Hamanaka came to light only because of his ever

increasing greed to repeat his initial success by trying to drive copper prices even higher. Analysts

said that it was time for LME to amend its rules and procedures to reduce its exposure to non-

member traders and ask its members to provide their client details in order to prevent debacles like

Sumitomo in future.

THE END RESULT

The disclosure of huge trading losses by Sumitomo, believed to be one of the most conservative and well-managed Japanese companies shook financial markets the world over. Occurring just after two major corporate disasters – Barings and Daiwa, analysts felt that the disclosure must lead to a serious introspection among various financial regulators and trading firms to improve the existing regulation and supervision procedures. Unlike the other two disasters, Sumitomo was able to overcome the losses since it had a net worth of $6 bn and another $8 bn in hidden reserves20. The losses estimated to be $2.6 bn amounted to only 10 per cent of Sumitomo‟s annual sales. Sumitomo was also able to prevent further escalation of losses by aggressive liquidation of its uncovered position under its new president Miyahara.

Hamanaka was charged in Tokyo with forgery and fraud. He was subsequently found guilty by the court on four counts of having forged the signatures of his bosses to keep secret his off-the-books trading and of having cheated Sumitomo Hong Kong to the tune of $ 770 mn. Hamanaka was sent to jail for eight years. Sumitomo also filed a civil suit accusing Hamanaka and his erstwhile boss Shimizu of having misutilized about $7 mn. Sumitomo was able to recover about $1 mn from Hamanaka‟s Swiss bank accounts. Merrill Lynch, which did not admit or deny any wrong doing, subsequently agreed to pay $25 mn to settle charges in the US and the UK for the role it played in the debacle. LME also imposed a fine of $10.2 mn on Merrill Lynch. Sumitomo launched a $760 mn lawsuit against Chase Manhattan and UBS in 1997. In 1998, in its efforts to improve transparency and management efficiency, Sumitomo adopted a new set of management principles (Refer Exhibit V).

20 Hidden reserves are the reserves created by a charge against earnings, to provide for changes in the value

of a company‟s assets. For example, accumulated depreciation and allowance for bad debts.

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Analysts believed that unless the senior managers of trading firms discontinued their cavalier

attitude towards monitoring, supervision and control there was every likelihood that the debacle

like Sumitomo would be repeated.

QUESTIONS FOR DISCUSSION:

1. Analyze the reasons that led to the copper-trading debacle at Sumitomo Corporation. Discuss

the importance of proper supervision and effective control systems to manage risks in a trading

firm. What steps could Sumitomo have taken to avoid huge losses in copper trading?

2. Discuss in detail how Hamanaka‟s unauthorized trading activities led to major losses at

Sumitomo.

3. The role of regulatory agencies in preventing major scams like Barings, Sumitomo and Daiwa

has always been debatable. What steps should regulatory authorities take to prevent the

occurrence of such debacles in future?

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Exhibit I

History of Sumitomo Corporation

December 1919 Established as Osaka Hokko Kaisha Ltd. (with a capital of 35 million

yen)

November 1944 Merged with Sumitomo Building Co. and renamed to Sumitomo Real

Estate and Building Co.

November 1945 Aiming to enter the trading business, renamed as Nihon Kensetsu

Sangyo Kaisha Ltd and started as a trading company

August 1949 Listed on the Osaka, Tokyo and Nagoya Stock Exchanges respectively

June 1952 Changed the company name to “Sumitomo Shoji Kaisha Ltd.”

December 1962 Departments and Sections integrated into Nine Business Divisions –

Iron & Steel, Nonferrous Metals, Electric, Machinery, Produce &

Fertilizer, Chemicals, Textile, General Products & Fuel, and Real Estate.

November 1970 Established Osaka Head Office and Tokyo Head Office respectively

November 1973 Listed on the Frankfurt Stock Exchange.

July 1978 Adopted the English company name "Sumitomo Corporation."

February 1998 Enacted Corporate Mission Statement

October 1998 Developed a 2-year „Reform Package,‟ as a mid-term management plan,

with the objective of „qualitatively improving the Integrated Business

Enterprise and realizing global consolidated management.‟

January 2000 Drew up the SC VALUES.

April 2001 Abolished the names „Osaka Head Office‟ and „Tokyo Head Office‟.

Reorganized the Head Office, which consists of six Corporate Groups,

nine Business Units and twenty-eight Business Divisions. Introduced

Regional Business Units in the Kansai, Chubu and Kyushu-Okinawa

regions.

Launched „Step Up Plan‟ as a mid-term management plan to expand the

Reform Package.

April 2003 Launched „AA Plan‟ as a new mid-term management plan to expand the

Step Up Plan.

Source: http://www.sumitomocorp.co.jp

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Exhibit II

Organization Chart of Sumitomo

Source: http://www.sumitomocorp.co.jp

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Exhibit III

Copper and Aluminium Cash Settlement Prices (1994-96)

Source: www-econo.economia.unitn.it

Exhibit IV

Copper Backwardation (1991-96)

Source: www-econo.economia.unitn.it

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Exhibit V

Sumitomo’s Management Principles

The business spirit of Sumitomo is a business and management concept that has continued to

flow throughout Sumitomo‟s operations for over 400 years. The Sumitomo Spirit was embodied

in the “Business Principles” drafted in 1891. The spirit is:

Sumitomo shall achieve strength and prosperity by placing prime importance on integrity

and sound management in the conduct of its business.

Sumitomo shall manage its activities with foresight and flexibility in order to cope

effectively with the changing times. Under no circumstances, however, shall it pursue easy

gains or act imprudently.

In 1998, we adopted the following „Management Principles‟ in order to develop a corporate

vision for the 21st century while still adhering to the Sumitomo Spirit.

To achieve prosperity and realize dreams through sound business activities.

To place prime importance on integrity and sound management with utmost respect for the

individual.

To foster a corporate culture full of vitality and conducive to innovation.

The Sumitomo Spirit and Management Principles are the ethical backbone of our company and

serve as the unwavering truths that support corporate governance. Realizing that, we have

engaged in studies concerning the optimal managerial system for our company, namely a

method of governance which is responsive to the trust placed in us by our shareholders while at

the same time making management that takes in the interests of all stakeholders a reality.

Ultimately, we view corporate governance as the „improvement of management efficiency‟ and

the „maintenance of sound management,‟ as well as the „securing of managerial transparency‟

which is required to accomplish the same.

Source: http://www.sumitomocorp.co.jp

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Additional Readings & References:

1. Fatigued, Economist, June 22, 1996.

2. Coming a Cropper in Copper, Economist, June 22, 1996.

3. Sumitomo’s Metal Fatigue, Economist, June 22, 1996.

4. Levinson, Marc, Bartholet, Jeffrey, The Mighty Copper King, Newsweek, June 24, 1996.

5. Serrill, Michael E., Billion Dollar Loser, Time International, June 24, 1996.

6. Fletcher, Mathew, Shameen, Asif, Sumitomo’s Shokku, asiaweek.com, June 28, 1996.

7. All that Glisters, Economist, June 29, 1996.

8. Egan, Jack, The Copper Debacle, US News & World Report, July 01, 1996.

9. Krugman, Paul, How Copper Came A Cropper, msn.com, July 20, 1996.

10. Fennell, Tom, Kakucji, Suvendrini, Denting Copper: How Far Will Japan’s Massive

Trading Scandal Spread? Macleans, August 01, 1996.

11. Holter, James T, Regulatory Rigmarole, Options & Derivatives Traders, August 1996.

12. Dorman, Bill, Sumitomo Losses Mount, money.cnn.com, September 19, 1996.

13. Szala, Ginger, The LME Talks Back, Futures: News, Analysis & Strategies for Futures,

Options & Derivatives Traders, October 1996.

14. Dorman, Bill, Copper Trading King Jailed, cnn.com, October 22, 1996

15. The Sumitomo Copper Fix, Multinational Monitor, May 1998.

16. Copper Scandal Just Won’t Go Away, Purchasing, September 02, 1999.

17. High Stakes, US Banker, December 2000.

18. Tschoegl, Adrian E, The Key to Risk Management, wharton.upenn.edu.

19. www.sumitomocorp.co.jp.

20. www.amm.com

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1. The Fall of Barings Bank.