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The Sumitomo Copper Fraud: Were there signs?

Rae Weston
MGSM
Abstract
Before the event itself, financial frauds in the making often send out clear signals to those willing
to see them. In “Silver Threads among the Gold” (1976 ) Henry Jarecki set out in advance of the
event how the Hunt brothers cornered the silver market. In the Nick Leeson case, the directors of
Barings Bank were made aware in January 1995 of the riskiness of its trading position by the
Singapore Financial Futures Exchange. (Jaffa, 1998) This paper investigates the Sumitomo case
and examines the signs that could have been recognized prior to the losses being officially
revealed. JEL#: G28, G38 Keywords: Financial Fraud, Sumitomo 2 The Sumitomo Copper
Fraud: Were there signs? I In “Silver Threads among the Gold”(1976 ) Henry Jarecki set out in
advance of the event how the Hunt brothers cornered the silver market. In the Nick Leeson case
the directors of Barings Bank were made aware in January 1995 of the riskiness of its trading
position by the Singapore Financial Futures Exchange. (Jaffa, 1998) This paper investigates the
Sumitomo case and examines the signs that could have been recognized prior to the losses being
officially revealed. II In June 1996 it was reported that an investigation by the UK Securities and
Investment Board (SIB) had revealed that losses of $1.8 billion had been accumulated from
unauthorized trading at Sumitomo Corporation, a leading copper dealer. The company attributed
blame for the losses to Yasuo Hamanaka, a former head of copper trading, but nevertheless
emphasized that it would stand behind its copper market obligations, and recognized that the
losses could rise if the copper price fell. The American Metal Market reported (June 17, 1996)
that: “Executives said they learned of the losses June 5 when Hamanaka allegedly admitted to
unauthorized trading. The admission followed the discovery in late April and early May of
unaccounted-for bank transactions that led to Hamanaka’s removal from trading and further
investigations led to the confession, executives said. A second unidentified trader who left the
company eight years ago was the only other one mentioned. The market Hamanaka had been
trading in was the London Metal Exchange forward market for copper. In this market, positions
are taken normally for three months, but there is an ability to roll positions forward, thereby
deferring the settlement and the crystallization of profit or loss date. Sumitomo was the largest
participant in the physical market for copper, handling twice the volume of its nearest
competitor. Hamanaka was known in the copper markets as “Mr. Five Percent”because
Sumitomo’s copper trading team traded approximately 500,000 metric tons of copper a year,
which was 5% of the total world demand for copper. Hamanaka, as quoted in the company’s
Annual Report in the early 1990s, explained the company’s significance in the market as
“attributable to expertise in risk management.” The Economist (June 22,1996) speculated that
Hamanaka may either have managed to convince his company that it owned copper which it did
not in fact possess, or that he had borrowed money to cover his losses. Although Sumitomo
relieved Hanamaka from trading in early May in order for him to help the two bodies with their
inquiries, Sumitomo did not recognize the losses until 3 June 5 and even then its actions were
only in response to a bank statement it had received crediting the company with funds from a
transaction it could not find. On June 24, the company announced that it was assembling an
investigation team (including a New York-based law firm, a US accounting firm and four or five
of its own executives from other divisions) to look into the copper trade losses. The president of
Sumitomo, Tomichi Akiyama said that he was “profoundly embarrassed” by the loss. In July, it
was established by ring-dealing members of the LME, and announced by Credit Lyonnais Rouse,
that “all credit lines and contractual documentation with Sumitomo had been properly processed
and authorized by officials designated by Sumitomo to have such powers and such authorities
were not exclusively in the hands of Hamanaka.” The requirements of the Securities and Futures
Act’s Adequate Credit Management Policy had been satisfied with respect to these transactions.
By August, it had been established that Hanamaka’s strategy had been to buy up physical copper,
store it in the LME warehouses and watch demand drive up the price, holding off short sells by
purchasing the other sides of those positions. This strategy unwound when Hanamaka was
relieved of his trading role in early May and could no longer counter short-selling. In September,
the Tokyo Prosecutors’ Office formed a special unit to investigate the affair and Sumitomo
voluntarily turned over data on both its corporate organization and copper trading to them. In
November, the prosecutors’ office formally indicted Hamanaka on four counts of forgery
allegedly in 1993 and 1994. Sumitomo also filed a fraud charge against him. In that claim
Sumitomo alleged that Hanamaka had swindled a Hong Kong subsidiary, Sumitomo Corp (Hong
Kong) Ltd into buying $770 million of copper that existed only on paper and using the proceeds
to cover losses from other deals. At his trial in February 1997, Hamanaka pleaded guilty to
charges of fraud and forgery in connection with losses which had now risen to $2.6 billion
incurred by Sumitomo over a ten year period. According to the prosecution case, Hanamaka and
his superior, Saburo Shimizu, began forward trading on the LME copper market in late 1985,
speculating without authorization, in an attempt to try to recoup a loss they had incurred from
physical copper trading in the Philippines. In fact, the losses rose to $60 million, at which point
Shimizu resigned. Both traders felt the losses were too great to report to their superiors.
Hanamaka believed it was not impossible to recover the losses through trading. Hanamaka and a
copper merchant firm entered into a contract to supply Sumitomo with a total of 1,194 million
metric tons of copper between 1994 and 1997. Almost half of the copper sold in 1995 and 1996
was sold back to the merchant’s supplier and never delivered. A term of the contract made it in
the traders’ interests for prices to rise above a pre-established minimum price, because Sumitomo
was obligated under the minimum price provision to buy copper at the highest price between
either the market price at the time of shipment or the minimum price set by Sumitomo during a
specified time period. Under the price-participation provision, the merchant firm was required to
pay Sumitomo 30% of the difference between the market price at the time 4 of shipment and the
minimum price on futures contracts purchased to hedge the supply contracts. Whenever copper
prices rose above the pre-established minimum price, the merchant firm and Sumitomo would
share in the price appreciation. In order to coordinate their trades, Hanamaka and the merchant
firm established accounts at a number of brokers, authorizing access to those accounts by using
Sumitomo’s name and credit line. To force up prices and liquidate their positions at a profit
Hanamaka and the merchant firm held all of the stocks in LME warehouses at different times
during the last quarter of 1995.Between them, Hanamaka and the merchant firm managed to
create artificial prices and price relationships. In a New York law suit which alleged that
manipulation between Sumitomo and, a merchant firm, Global Minerals had occurred between
June 1994 and June 1996, Sumitomo agreed in August 1998 to pay $99 million. In a California
suit, Sumitomo agreed to pay $42.5 million. In March 2001, five former directors of Sumitomo
agreed to pay a total of $3.55 million to the company to settle a shareholder lawsuit stemming
from losses due to illegal copper trading. The settlement amounted to approximately half the
retirement benefits received by the former directors. Were there signs? Sumitomo had had its
attention drawn to possible irregularities in its copper market dealings before: first in 1991, by
the LME when David Threlkeld, one of its metal brokers, reported being asked by Hamanaka for
an invoice for non-existent trades; secondly in 1994, when an inquiry by the UK Securities and
Futures Authority (UK) into the relationship between Winchester and a Chilean trader acting for
Codelco led the authority to notify Sumitomo that Winchester had made most of its money
acting as a broker for Sumitomo; and, third, in early 1996, when the SIB and the US CFTC
began to investigate the copper market. It was clear that the company’s activities in the market
would be of interest to them. Had the second of these warning signs been investigated, this might
have led to an earlier discovery of the irregularities. The complicity of others within Sumitomo
which is suggested by the July announcement by Credit Lyonnais Rouse, appears to have been
an intervening event which may have prevented early recognition. This however, seems at least
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