Fifteen months after the AIJ scandal rocked the Japanese pension industry, the Financial Services Agency (FSA) has uncovered another suspected fraudulent investment firm, MRI International. Based in Las Vegas, but with a client base consisting of many Japanese high net-worth individuals, the firm is suspected of having lost the bulk of more than ¥136bn ($1.4bn) of customer funds, whilst submitting false reports to investors and the regulator.

 The Securities and Exchange Surveillance Committee (SESC), effectively the inspection unit of the FSA, found the firm had not been investing the money entrusted to it since at least 2011, but instead paid dividends and redemption proceeds from funds placed by new clients, effectively running the type of Ponzi scheme international investors have come to know through Bernard Madoff and Japanese through last year’s AIJ fraud.

This MRI alleged fraud-case is different from AIJ in that it does not involve pension funds, the focus of the SESC’s attention for the past 15 months. That may well be a reflection of the adjustments implemented rapidly by investment management firms and regulators to meet the compliance challenges around doing business with pension funds uncovered by the AIJ incident.

The use of off-shore vehicles to channel investments by Japanese pension funds unveiled not only the vulnerability to domiciles with light regulations and fewer checks and balances to safeguard proper independent valuations, segregation of accounts etcetera, but also a division of roles and responsibilities between a pension fund, its investment manager and the trustee/custodian that appears to have become very ambiguous and blurred.

With the exception of only very few, Japanese pension funds must be treated as amateur investors assumed incapable of, and therefore prohibited from, making their own investment decisions. They are obliged to appoint an investment management firm, duly registered with the FSA, provide this firm with investment guidelines and, on its behalf, let this firm make the investment decisions necessary to implement the mandate in accordance with the investment guidelines at the manager’s discretion.

The pension fund is prohibited from selecting a security or portfolio of securities be it an individual stock, bond, structured note or mutual fund. For segregated portfolios, this framework is clear and transparent. Take a global bond mandate: the pension fund is assumed not to be a specialist in bonds, so enters into a discretionary investment management agreement to allow the specialist manager to manage the portfolio according to its guidelines which might include items such as duration leeway, currency- and credit rating exposures etc.

However, the framework becomes ambiguous in the case of funds. Let’s assume a pension fund likes a particular non-Japanese global bond fund. First of all it is prohibited from investing in this fund directly but, more than that, strictly speaking it is prohibited from instructing its investment manager to invest on its behalf in this particular fund (by the way: the registered investment manager is also prohibited from ‘selling’ this off-shore fund unless it is registered as a Type 1 financial instruments dealer, making it effectively a securities broker).

Following the letter of the regulations, the only thing a pension fund, who would insist on having exposure to a fund of its choosing, can do is give its investment manager a mandate with investment guidelines that are specified in such a way as to leave the investment manager with no other option than to invest in that particular global bond fund without instructing it to do so directly.

Prior to AIJ, this practice of putting the horse behind the cart was not unusual: pension funds, although assumed to be amateurs relying on professional asset managers to make discretionary investment decisions oftentimes acted as professionals ‘buying’ investment products from off-shore hedge-funds or investment banks, pulling in a locally registered asset manager only after the fact in order to facilitate a transaction. Judging from recent disciplinary measures against asset managers, for example late last year against United Investments, who was found wanting in performing prior-to-investment due-diligence, on-going monitoring and continuous client reporting on a private equity fund investment, the SESC now seems more focussed on enforcing that the respective roles of discretionary investment manager, pension fund and trustee/custodian are properly performed.

It may be too late for the wealthy individuals who invested with MRI International, but the FSA’s strengthened inspection regime following AIJ has raised the stakes for asset managers doing business with pension funds in Japan.

Oscar Volder CFA is Head of Institutional Sales at BNP Paribas Investment Partners Japan.