Back to Contents of Issue: February 2000


Last year, dynamic young tech companies attracted considerable attention on Japan's over-the-counter (OTC) market. Engineering firm Future Systems Consulting saw its first-day trading price increase five times over the prelisting price. E-commerce service provider Softbank Technologies fetched an initial price of \40,000 per share, about 8.7 times higher than the prelisting price, and ISP interQ opened 4.5 times higher than the premarket price.

Investors in Japan, having watched hot Net stocks skyrocket on the US Nasdaq over the past few years, are snapping up shares of upstart tech companies. Yahoo Japan, Nippon Oracle, and Trend Micro have each enjoyed a combined market cap of more than \1 trillion; interQ traded at 512 times projected earnings on its first day of trading.

It's been a nice rally. The Nikkei OTC average index roared back from an October 1998 bottom of \610 to \2,400 last November -- a quadruple increase that beat all the world's major markets. The OTC's market cap went from \8 trillion to \14 trillion in June 1999, then to more than \25 trillion in December. In 1999, at least 73 companies brought IPOs to the market, compared with 62 in 1998.

In the past, foreign investors have been loyal players in the OTC market, but last year individual investors, pension funds, and investment trust funds (elsewhere known as mutual funds) also started playing the market in earnest. From October 1998 to Sept-ember 1999, foreign investors were net buyers of \132 billion, trust banks managing corporate pension funds \25.1 billion, and investment trust funds \19.6 billion. Meanwhile, individuals were net sellers of \125 billion.

"Unlike long-term investors, such as foreign institutions or Japanese pension funds, individuals are short-term holders of IPO stocks," says Seiichiro Samejima, research officer at Ichiyoshi Securities, a brokerage house specializing in OTC stocks. "But they came to account for as much as 60 percent of the monthly purchase of OTC stocks, from 30 percent in autumn 1998."

Another factor behind the rally is a change in the way the OTC prices IPOs. In late 1998, a book-building formula was adopted in favor of an auction system, which had led to a shares-for-favors political scandal and discouraged participation by some foreign investors. Using the new book-building method, underwriters build a "book" by accepting orders from fund managers, indicating the number of shares desired and the price they're willing to pay. This leads to a price that more accurately reflects the actual demand for a stock. The new method has led to more foreign investment, which helped further fuel the rally.

The OTC, however, is facing considerable challenges, both from within and without. Traditionally, the market has been a graveyard for companies delisted from the Tokyo Stock Exchange, and on the IPO front, the OTC faces serious competition from the TSE's new Mothers exchange and from the upcoming Nasdaq Japan.

The OTC is run by the Japan Securities Dealers Association, only half of which is represented by the securities industry. The other half is run by "celestial descendents" -- senior officials from the former Ministry of Finance who get cushy jobs when they retire. As a result, the association has become extremely bureaucratic. One official from a foreign broker who was asked to join "the committee to renovate the OTC" says he's fed up with the association's bureaucratic management. Some companies list on the OTC merely for tax reasons; heirs of company founders have found that a good way to avoid the expensive inheritance tax -- which can be as high as 70 percent on assets of \2 billion or more -- is to list on the OTC. Investors, for obvious reasons, have had a cool response to these companies.

The OTC also faces serious competition from Mothers and Nasdaq Japan, competition made possible by the sweeping financial-industry deregulation carried out in 1998. According to a November survey by the Nihon Keizai Shimbun, as many as 73 percent of venture companies looking to go public want to list their stocks on Nasdaq Japan, followed by 43 percent who want to list on Mothers. Thirty-five percent say they still plan to go to the OTC.

Opened late last year by the TSE, Mothers is designed specifically with high-growth tech stocks in mind. Its listing requirements are lenient enough for a startup with a negative net worth to join, but, in exchange, a company must provide more transparency and greater financial disclosure -- posting earnings reports quarterly and holding shareholder meetings at least twice a year. (The OTC market has a special section to register companies swimming in red ink, but auditing of their books for at least one full fiscal year is required before listing.) In addition to providing a relatively fast way to go public, Mothers also greatly reduces the cost of listing.

Mothers' leniency, however, has caused concern in Japan's tech community. "Mothers provides Japan's up-and-coming Internet companies with a fantastic opportunity to raise capital to further develop their businesses," says Tim Williams, president of a startup called ValueCommerce. "One major concern I have is that the quality and performance of the initial listees will have a major impact on the reputation of Mothers and thus the budding Internet industry in Japan. Companies need to be carefully screened, as a few lemons could have a very negative impact on the market. Companies looking to list on Mothers, especially those looking to list as quickly as they possibly can, also need to take a responsible attitude, as at the end of the day, if we as venture companies do not produce leading technologies, profitability, and a good return on investment to all our shareholders, we cannot expect the ongoing support of investors."

Quality concerns of another sort were expressed by both the National Police Agency and the Metropolitan Police Department. The agencies caught wind of news that yakuza gangsters' corporate brethren were preparing to list on the exchange to raise money for their crime syndicates. The authorities have reportedly asked senior TSE officials for tough screening to prevent the exchange from becoming a hotbed of such activity. Despite such concerns, however, Mothers has quickly established itself as the market for companies wanting to go public quickly and easily. Liquid Audio Japan switched to Mothers after having initially planned to go public over the OTC, and was joined by Internet Research Institute (see "First to List on TSE's Mothers Exchange Score Bonus Buzz"). Ryuji Ide, president of Skymark Airlines, says his company also made the switch. Worse for the OTC, a rule change now allows some companies to go public directly on the TSE itself (without first going through the OTC or a local exchange), and from last August some 35 OTC companies jumped ship to the TSE.

But this doesn't necessarily foretell a major liquidity shift from the OTC to the TSE and Mothers. "There will be no immediate shift of liquidity to the Mothers market, as the major investors in OTC stocks were investment trust funds selling under names like 'OTC Growth Fund,'" says Ichiyoshi Securities' Samejima. "These funds are unlikely to invest in high-risk stocks on Mothers."

The TSE moved quickly in getting Mothers up and running -- partly as an offense against the OTC and partly as a defense against Nasdaq Japan, which is slated to open by year's end; Mothers expects to have some 70 companies listed by the time Nasdaq Japan goes online. A joint venture between Nasdaq and Softbank (with a tie-in to the Osaka Securities Exchange), Nasdaq Japan will have the toughest registration requirement for tech startups, assuming it abides by the stringent rules of the US Nasdaq, where money-losing companies wanting to register must clear hurdles like minimum net asset value and market capitalization level.

The importance of the tie-in with Nasdaq US shouldn't be underestimated. Nasdaq Japan says that its brand will prove attractive to high-tech companies going public, and there's little doubt that American investors will provide a great deal of liquidity to the exchange. Of all the markets in Japan, Nasdaq has the best potential to provide US capital with the transparent and "safe" venue it has long sought, helping fuel the same hyper investment climate that has propelled US dot.com valuations to stratospheric heights.

Worried that liquidity will flow to Nasdaq Japan at its expense, the OTC is now soliciting small companies listed on regional exchanges like Nagoya, Sapporo, Niigata, and Kyoto. "Increasing liquidity will be a key to surviving the competition," says Hideo Fujino, a portfolio manager at Jardine Fleming Investment Trust and Advisory.

The OTC has a dilemma: Should it lower the bar for listing to the level of Mothers, or maintain strict listing requirements as a seal of quality? To save its sinking image, says Sadakazu Ohsaki, head of the Capital Market Research Unit of Nomura Research Institute, "the OTC should enhance its image as the market for top-notch growth companies."

One idea being circulated is that the OTC should have two sections: the first for blue-chip stocks with high-growth potential, the second for weaker stocks with poor price-to-book ratios. Many brokerage houses think the Securities Dealers Association needs to be revamped. One suggestion is to shift the administrative and organizational functions of the OTC to a corporation that would be able to raise funds and thus compete more effectively in an ever-changing business climate.

For its part, the TSE, which has for decades been the primary fund-raising marketplace for Japanese companies and the main pillar of Japan's financial markets, is now facing a challenge to survive. Having become larger than the New York Stock Exchange at one point, the TSE last April saw its market cap fall to nearly half its peak level. One of the TSE's survival strategies is to join forces with overseas exchanges, and the first preliminary partnership was formed with the NYSE in February 1999.

Of course, cooperation is another possibility. Last March, in the midst of all the strategizing, an alliance taskforce was set up by the TSE to discuss the introduction of a mutual listing system and the exchange of market information.

In the final analysis, the establishment of new markets in Japan and the revitalization of existing ones can only help boost the overall investment climate. The first and perhaps most important benefit is that for the average Japanese looking to maximize returns, there will be more choices and improved transparency -- something that individual investors outside Japan have long enjoyed.

Second, industry watchers here are looking forward to a substantial reduction in the longtime practice of maintaining corporate crossholdings -- two companies agreeing to hold fixed amounts of each other's stock as a way to cement business ties. As a consequence, it has been common for only small fractions of some companies' outstanding shares to change hands, leading to constipated markets.

And finally, the Japanese appear to be waking up to the potential of US capital. Players in Japan know that after some five-plus years of Net boom experience in the US, attracting this extremely savvy American money will require much more than a business-as-usual approach. Mothers, Nasdaq, and a revitalized TSE and OTC look like first steps in the right direction.

Timeline of Japan's Stock Markets
1963 The OTC market opens. It's meant to be a sort of Nasdaq in Japan, but it becomes an unloved stepchild of Japan's stock market.
December 1989 TSE market cap peaks at \611 trillion. At one point it becomes larger than the New York Stock Exchange.
1990 Economic bubble bursts.
October 1991 Jasdaq, a computerized system for stock quotations, is launched.
Late 1997 Fourth-largest and eighth-largest brokerage houses -- Yamaichi Securities and Sanyo Securities -- go under.
1998 Serious economic recession and credit tightening decimate 75 venture companies. Government announces sweeping financial-industry deregulation, allowing direct competition with the OTC. TSE and Nasdaq spot the opportunity.
June 1998 Nasdaq announces major push into Japan. Competition from local exchanges at this point looks pretty thin.
Late 1998 OTC changes rules so that IPO pricing is based on a book-building system instead of an auction one. The latter led to a shares-for-favors political scandal and locked out many foreign brokers.
Early 1999 OTC rebounds, due largely to influx of foreign investors.
March 1999 TSE taskforce created to discuss exchange of market information and introduction of a mutual listing system.
April 1999 TSE moves to computerized trading. Its market cap is at \332 trillion, about half of the bubble-era peak value.
August 1999 TSE rules change allows venture companies to list on the First Section without first going public on the OTC or regional markets.
October 1999 Deregulation of brokerage commissions. Online trading takes off.
November 1999

TSE opens new Mothers exchange, beating Nasdaq Japan by at least a year. Listing requirements are more lenient than those of Nasdaq Japan. Mothers expects to have 70 companies listed by the time Nasdaq Japan opens.

The Wall Street Journal reports that Japan's eight exchanges have only about 2,500 companies listed on them, compared to some 8,850 in the US -- 5,100 on Nasdaq, 3,100 on the NYSE, and 650 on the American Stock Exchange.

Late 1999 Some 30 OTC companies jump ship to the TSE, including seven that go straight to the First Section.
December 1999 Two hot tech companies -- Internet Research Institute and Liquid Audio Japan -- choose to list on Mothers instead of the OTC.
Fall of 2000 Nasdaq Japan opens. A joint venture between the Nasdaq and (expected) Softbank, it works closely with the Osaka Securities Exchange to lend it Japanese credibility.

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