Annual and Transition Report (foreign Private Issuer) (20-f)

PART I

*(1) Share and per share data give effect to a 2-for-1 share split effective on October 1, 2011 and April 1, 2012, and a 10-for-1 share split effective on April 1, 2014, which represented one ADS for two common shares, as if such share split had occurred on April 1, 2011.

Financial covenants

There are restrictive covenants measured annually as of March 31 of each year related to bank borrowings of ¥1,136,665 thousand under long-term syndicated term loan agreements with consortium of Japanese banks as of March 31, 2018, including requirements to maintain a minimum level of net assets and ordinary income in the stand-alone and consolidated financial statements of the Company in accordance with accounting principles generally accepted in Japan (“Japanese GAAP”).  The Company is required to maintain net assets at a level which is at least 75% of (a) net assets as of March 31, 2016; ¥5,187,455 thousand on a stand-alone basis and ¥4,657,450 thousand on a consolidated basis under Japanese GAAP or (b) net assets at the end of the previous year, whichever is higher. The ordinary income covenant states that FRONTEO and its consolidated subsidiaries and FRONTEO as a stand-alone entity shall not record ordinary losses in any two consecutive fiscal years.

In addition, there are restrictive covenants measured annually as of March 31 of each year related to bank borrowings of ¥1,761,114 thousand under long-term loan agreements with a Japanese bank as of March 31, 2018, including requirements to maintain a minimum level of net assets and ordinary income in the stand-alone and consolidated financial statements of the Company in accordance with Japanese GAAP.  The Company is required to maintain net assets at a level which is at least 75% of (a) net assets as of March 31, 2015; ¥5,032,824 thousand on a stand-alone basis and ¥5,220,772 thousand on a consolidated basis under Japanese GAAP or (b) net assets at the end of the previous year, whichever is higher. The ordinary income covenant states that FRONTEO and its consolidated 

subsidiaries and FRONTEO as a stand-alone entity shall not record ordinary losses in any two consecutive fiscal years.

In addition, there are restrictive covenants measured annually as of March 31 of each year related to bank borrowings of ¥1,630,069 thousand under long-term loan agreements with a Japanese bank as of March 31, 2018, including requirements to maintain a minimum level of net assets and ordinary income in the stand-alone and consolidated financial statements of the Company in accordance with Japanese GAAP.  The Company is required to maintain net assets at a level which is at least 75% of (a) net assets as of March 31, 2015; ¥5,220,772 thousand on a consolidated basis under Japanese GAAP or (b) net assets at the end of the previous year, whichever is higher. The ordinary income covenant states that FRONTEO and its consolidated subsidiaries and FRONTEO as a stand-alone entity shall not record ordinary losses in any two consecutive fiscal years.

In addition, there are restrictive covenants measured annually as of March 31 of each year related to a short-term revolving credit facility agreement of ¥1,000,000 thousand with a consortium of Japanese banks as of March 31, 2018, including requirements to maintain a minimum level of net assets and ordinary income in the stand-alone and consolidated financial statements of the Company in accordance with Japanese GAAP. The Company is required to maintain net assets at a level which is at least 75% of (a) net assets as of March 31, 2017; ¥6,548,327 thousand on a stand-alone basis and ¥5,018,678 thousand on a consolidated basis under Japanese GAAP or (b) net assets at the end of the previous year, whichever is higher. The ordinary income covenant states that FRONTEO and its consolidated subsidiaries and FRONTEO as a stand-alone entity shall not record ordinary losses in any two consecutive fiscal years.

As of March 31, 2018 the Company was not in compliance with these restrictive covenants. The non-compliance was principally the result of covenants that FRONTEO is required to not record ordinary losses in any two consecutive fiscal years, measured under Japanese GAAP. The non-compliance occurred as of March 31, 2018 when for the second consecutive year FRONTEO recorded an ordinary loss of ¥16,572 thousand on a consolidated basis measured under Japanese GAAP.  The Company sought and obtained waivers from all of the related lending intuitions eliminating the obligation to repay the debt currently. On the maturity date of July 23, 2018, the Company repaid ¥1,000,000 thousand of short-term borrowing under the revolving credit facility agreement. On the same date, the Company executed a ¥1,100,000 thousand borrowing under the same short-term revolving credit facility agreement with consortium of Japanese banks. However, the same covenants is in place as of March 31, 2019, and as a result if the Company makes an ordinary loss of any amount in the year ending March 31, 2019 (at the next measurement date) the debt will become due and payable once the audited results are reported in June 2019. The Company has completed a recent restructuring of its US operations and recently has made significant improvements in the profitability of its AI business segment, and as a result the planned results for the year ending March 31, 2019 is that the Company will turn an ordinary profit of ¥600,000 thousand on a consolidated basis, and ¥736,000 thousand on a stand-alone basis, avoiding the default on the short-term and long-term debt. If the current plan is not achieved the Company will have to take additional actions which might include liquidation of appreciated asset, seeking additional waivers or other relief from the lending intuitions. There is no guarantee that the Company will achieve the plan for 2019 or that if that any other actions taken would be ultimately successful in avoiding the repayment of significant debt obligations that may be accelerated by the institutional lenders as a result of non-compliance with these restrictive covenants.

As of March 31, 2018, the Company pledged the common stock of its subsidiary in the U.S. with carrying amount of ¥5,867,417 thousand as security for a borrowing from a bank of ¥1,708,602 thousand.

On December 15, 2017, the Company and Bank of Mitsubishi UFJ, Ltd. entered into a ¥500,000 thousand short-term loan agreement with a maturity date of June 15, 2018. The loan was secured by the shares of Focus Systems Corporation (“Focus Systems”) having the book value of ¥848,700 thousand on of March 31, 2018.

The company fully paid the loan on June 15, 2018, and the security interest in the shares of Focus Systems was released.

Dividends

The Companies Act of Japan (Companies Act) permits companies to distribute dividends-in-kind (non-cash assets) to shareholders subject to certain limitations and additional requirements. Semiannual interim dividends may also be paid once a year upon resolution by the Board of Directors if the articles of incorporation so stipulate. The Companies Act provides certain limitations on the amounts available for dividends or the purchase of treasury stock. The limitation is defined as the amount available for distribution to the shareholders, but the amount of net assets after dividends must be maintained at no less than ¥ 3 million.

The amount of retained earnings available for dividends under the Companies Act is based on the amount of retained earnings recorded in the Company’s general books of account prepared using generally accepted accounting practices in Japan. The adjustments included in the accompanying consolidated financial statements for U.S. GAAP purposes but not recorded in the general books of account have no effect on the determination of retained earnings available for dividends under the Companies Act.

On June 25, 2013, our Board of Directors declared a year-end cash dividend of ¥50 per share of common stock to shareholders of record as of June 26, 2013. The aforementioned per share cash dividends do not reflect a 2-for-1 share split effective on October 1, 2011 and April 1, 2012 and a 10-for-1 share split effective on April 1, 2014. We did not declare a cash dividend in 2014. On June 23, 2015, our Board of Directors declared a year-end cash dividend of ¥3 per share of common stock, payable to shareholders of record as of March 31, 2015.  On June 29, 2016, our Board of Directors declared a year-end cash dividend of ¥3 per share of common stock, payable to shareholders of record as of March 31, 2016. The dividends declared in June 2013, 2015 and 2016 totaled ¥159.7 million, ¥106.5 million and ¥107.3 million respectively. We did not declare a cash dividend in 2018.

In appropriate circumstances, our Board of Directors may determine in its discretion, within the limits of the Companies Act, to declare dividends in the future, but there can be no assurance that any such dividends will be declared or paid at any time.

Exchange Rates

The following table sets forth, for the periods and dates indicated, information concerning the noon buying rate for Japanese yen announced by the Federal Reserve Bank of New York, expressed in Japanese yen per $1.00. The noon buying rate as of June 30, 2018 was $1.00 = ¥110.71. The Company does not intend to imply that the Japanese yen or U.S. dollar amounts referred to in this annual report could have been or could be converted into U.S. dollars or Japanese yen, as the case may be, at any particular rate, or at all.

* For fiscal years, calculated from the average of the exchange rates on the last day of each month during the period. Average exchange rate of fiscal year ending March 31, 2019, calculated based on the month-end exchange rates of April 1, 2018 through July 13, 2018.

3.B.        CAPITALIZATION AND INDEBTEDNESS

Not applicable.

3.C.      REASONS FOR THE OFFER AND USE OF PROCEEDS

Not applicable.

3.D.      RISK FACTORS

Risks Related to Our Business

We may not be able to achieve our expected revenues, operating income or net income in the future due to several factors involving our business operations, including a decrease in our revenue from our eDiscovery business.

Our expected levels of revenue, operating income or net income may not be achieved due to several factors, including, but not limited to:

We may not be able to comply with the financial covenants related to our bank borrowings, syndicated loans and/or revolving credit facility with the financial institutions and we may not be able to obtain extensions of the maturity of the outstanding loans, causing   a significant impact on the Company’s ability to continue as a going concern.

We have a significant amount of short-term and long-term bank borrowings that provide us with important sources of funds for acquisitions of business, capital equipment and working capital needs to support our business growth and technology development. 

There are restrictive covenants related to these borrowings, including requirements to maintain a minimum level of net assets and ordinary income in the stand-alone and consolidated financial statements of the Company, measured under accounting principles generally accepted in Japan. The ordinary income covenant states that the Company shall not record ordinary losses in any two consecutive fiscal years in the stand-alone and consolidated financial statements of the Company.

As of March 31, 2018, the Company was not in compliance with certain of these restrictive covenants due to the consecutive ordinary losses. Subsequent to year end, the Company received a waiver from each of the banks for which the covenant was breached.

If we continue to incur ordinary losses and fail to maintain a minimum level of net assets and ordinary income as stipulated in the financial covenants, the lending institutions may not be willing to extend the maturity of the outstanding loans and may accelerate the amounts we have borrowed under the various loan agreements, which would cause a significant impact on our ability to continue as a going concern.   

For further information of financial covenants, see “Capital Resources” in Item 5B.

Our business may be adversely affected if our systems used in eDiscovery or forensics services of our Legal Tech business segment suffer interruptions, errors or delays.

Interruptions, errors or delays with respect to our systems used in forensics or eDiscovery services of our Legal Tech business may be caused by human errors or natural factors, many of which are beyond our control, including, but not limited to, damage from fire, earthquakes or other natural disasters, power loss, sabotage, computer hackers, human errors, computer viruses and other similar events. Some of our computer and networking equipment is located in earthquake-prone areas. Any disruption, outages, or delays or other difficulties experienced by any of our technological and information systems and networks could result in a decrease in new or existing accounts, loss or exposure of confidential information, reduction in revenues and profits, costly repairs or upgrades, reputational damage and decreased consumer and corporate customer confidence in our business, any or all of which could have a material adverse effect on our business, financial condition and results of operations.

We may not achieve our financial targets or maintain our current level of total revenue, operating income or net income if the economy in the United States or Asian countries, including Japan, deteriorates or does not improve.

Our business is principally conducted in Japan, other Asian countries and the United States, and most of our revenues are from clients operating in the United States and Asia. If the United States and Asian economies deteriorate or do not improve, it may become difficult to maintain our current level of revenue and operating margins or achieve our expected revenues, operating income or net income.

We have taken precautions to mitigate the inherent risks of natural disasters such as earthquakes and tsunamis by enhancing our business continuity planning and investing in additional data centers both inside and outside of Japan. However, if an environmental catastrophe were to occur or should regions in which our data centers are located experience the disruption of social infrastructure or power shortages and other impacts due to similar natural disasters, our backbone network and service facilities could fail and as a result, we may suffer direct and indirect damages, which may adversely affect our financial condition and results of operations.

Our mergers and acquisitions may not achieve expected benefits, and may increase our liabilities, disrupt our existing business and harm our operating results.

We acquired TechLaw Solutions, Inc. (now “FRONTEO Government Services, Inc.”), EvD, Inc. (now “FRONTEO USA”) and Essential Discovery, Inc. (“EDI”) to develop sales channels in the U.S. and to enhance our competitiveness in the eDiscovery market. As a result, we incurred significant expenses from the acquisition and integration of the business operations. The benefits we expect to receive from mergers and acquisitions will depend on our ability to successfully conduct due diligence, negotiate the terms of the acquisition and integrate the acquired business into our systems, procedures and organizational structure. Any inaccuracy in our acquisition assumptions or any failure to uncover liabilities or risks associated with the acquisition, make the acquisition on favorable terms, integrate the acquired business or assets as and when expected or retain key employees of the acquired company may reduce or eliminate the expected benefits of the acquisition to us, increase our costs, disrupt our operations, result in additional liabilities, investigations and litigation, and may also harm our strategy, our business and our operating results. The failure to achieve expected acquisition benefits may also result in impairment charges for goodwill and purchased intangible assets.

We could incur impairment charges for goodwill, intangible assets and other long-lived assets.

We have significant amounts of goodwill, intangible assets and other long-lived assets. A decline in financial performance, market capitalization or changes in estimates and assumptions used in the impairment analysis, which in many cases requires significant judgment, could result in impairment charges of these assets.

Goodwill is not amortized and is tested annually for impairment of the fiscal year and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value below its carrying amount. In assessing goodwill for impairment, we have the option to first perform a qualitative assessment to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. Reporting units are our operating segments. If we determine that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, no additional tests to assess goodwill for

impairment are required to be performed. If we conclude otherwise or elect not to perform the qualitative assessment, then it is required to perform the first step of a two-step impairment review process. If the carrying amount of a reporting unit exceeds its fair value, we then perform the second step of the goodwill impairment test to measure the amount of impairment loss, if any, and an impairment charge is recorded for the amount.

If we fail to maintain and manage our confidential customer information, or if our technical systems suffer interruption or damage, we could be subject to lawsuits, incur expenses associated with our security systems or suffer damage to our reputation.

We maintain and manage confidential information and/or privileged data obtained from our clients. We exercise care in protecting the confidentiality and integrity of such information and take steps to ensure its security. However, we can give no assurance that the steps taken by us in this regard will be adequate to protect our clients’ confidential information or privileged data. A disaster could interrupt our services for an indeterminate length of time and severely damage our business, prospects, financial condition and results of operations. Our systems and operations are vulnerable to damage or interruption from fire, floods, network failure, hardware failure, software failure, power loss, telecommunication failures, computer viruses, denial of service attacks, penetration of our network by unauthorized computer users and computer hackers, cyber-attack, sabotage and other similar events, and other unanticipated problems. In addition, despite internal controls, misconduct by an employee could result in the improper use or disclosure of confidential information.

Any of the disruptions or events listed above could cause material interruptions or delays in our business, resulting in the loss of data or rendering us unable to provide services to our clients. In addition, a breach of our security measures could result in the destruction or misappropriation of valuable information or disrupt our operations. Although we have taken measures that we consider to be prudent and adequate to protect against these events, we may not have developed or implemented adequate protections or safeguards to overcome the damage they may cause. We also may not have anticipated or addressed many of the potential events that could threaten or undermine our data systems. If any material leak of clients’ information were to occur, we could be subject to lawsuits for damages from our clients, incur expenses associated with repairing or upgrading our security systems and suffer damage to our reputation that could result in a material decline in clients as well as an increase in service cancellations. The realization of these or similar risks may have a material adverse effect on our business, financial condition and result of operations. We are required to continuously evaluate and enhance our security measures, including systems designed to block unauthorized access and have made expenditures for these purposes in recent years to continuously enhance our security measures including systems to block unauthorized access. Although we have not had significant cybersecurity incidents, if we fail to protect our data center facilities and client confidential information from unforeseeable incidents, we may suffer direct and indirect damages, which may adversely affect our financial conditions and results of operations.

If we fail to effectively manage our growth, our business, financial condition, results of operations and business prospects may be materially adversely affected.

We have limited operational, administrative and financial resources, which may be inadequate to sustain our rapid growth and planned expansion. If our customer base continues to expand, investments in our technology platform, facilities and other areas of operations, including customer service and sales and marketing, will also increase. Our future success will depend on, among other things, our ability to effectively maintain our relationships with our key clients, to continue training, motivating and retaining our key employees and attract and integrate new employees, and to maintain adequate controls and procedures to ensure that our periodic public disclosure under applicable laws, including U.S. and Japanese securities laws, is complete and accurate.

We have experienced a period of rapid growth and expansion that has placed, and continues to place, significant strain on our management personnel, systems and resources. To accommodate our current and planned growth we anticipate that we will need to implement a variety of new and upgraded operational and financial systems, procedures and controls, all of which require substantial commitment of financial and management resources. We also will need to continue to expand, train, manage and motivate our workforce, and manage our relationships with clients. These efforts require substantial management efforts and skills and may incur additional expenditures.

If we fail to keep up with the rapid technological changes in our industry, we may lose clients due to obsolete services.

Our markets are characterized by:

We believe that the most recent version of Lit i View (version 7.16, released in May 2018), which features improved processing capability for Asian language utilizing our AI technology combined with an ability to provide one-stop services for the entire eDiscovery process for our customers provides significant improvement in the speed and accuracy of our primary eDiscovery software, not only compared to the previous version of Lit i View but also compared with Asian language products of our competitors. However, if we fail to obtain access to new or important technologies or to develop and introduce new services and enhancements that are compatible with changing industry technologies and standards and customer requirements, we may lose clients.

Our pursuit of necessary technological advances will require us to display unwavering commitment and a substantial investment in time and expense. Some of our competitors have greater financial and other resources than we do and, therefore, may be better able to meet the time and expense demands of achieving technological advances. This may allow our competitors to respond more quickly to new and emerging technologies and standards or invest more heavily in upgrading or replacing equipment to take advantage of new technologies and standards.

We face significant competition and may be unable to compete successfully against our competitors, which would have a material adverse effect on our business and results of operations.

Our primary competitors are companies with long established eDiscovery operations, which have significant, and often multi-faceted, operations with law firms and companies operating internationally. Many of our competitors have significantly greater financial resources, longer operating histories and more experience in attracting and retaining clients and managing relationships with the law firms and companies that constitute our target clients than we do. They may compete with us for clients in a variety of ways, including, without limitation, with respect to price and their more extensive eDiscovery and other analytical experience. If any of our competitors provide or develop comparable or superior computer forensic or eDiscovery services, the results would have a material adverse effect on our results of operations.

We depend on our key personnel for the success of our business and losing their services would severely disrupt our business.

Our future success is heavily dependent upon the continued service of our key executives, including Masahiro Morimoto, our founder, Chairman and Chief Executive Officer, and Naritomo Ikeue, our Executive Vice-President and Chief Operating Officer, among others. If we lose the services of senior members of our management or other key employees, we may not be able to locate suitable or qualified replacements and we may incur additional expenses to recruit and train new personnel, which could severely disrupt our business and growth. In addition, if any of these key executives or employees joins a competitor or forms a competing company, we could lose clients. Each of our executive officers has entered into an employment agreement with us. We do not maintain key-man life insurance for any of our key executives. Competition for qualified individuals could cause us to offer higher compensation and other benefits to attract and retain them, which could materially and adversely affect our financial condition and results of operations.

We require additional human resources and incur increased costs and administrative workload as a result of being a U.S. public company.

As a public company in the United States, we are subject to a number of regulatory requirements, including the reporting requirements of the Securities Exchange Act of 1934, as amended ( “Exchange Act”), the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley Act”), and the regulations promulgated thereunder, and the listing standards of the Nasdaq. Although we are required to comply with

Section 404(a) of the Sarbanes-Oxley Act when filing our annual report on Form 20-F for the fiscal year ended March 31, 2018, as an emerging growth company, as defined in Section 2(a) of the Securities Act of 1933, as amended (Securities Act), we have decided to take advantage of the exemption provided by the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”), which, assuming we continue to be an emerging growth company, allows us to delay complying with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002 until we are required to file our annual report on Form 20-F for the fiscal year ending March 31, 2019. Even though, as a foreign private issuer, some of these requirements may be more relaxed than they would be if we were a U.S. corporation, we will incur significant legal, accounting and other expenses that we did not incur prior to becoming a public company in the United States. We expect that these rules and regulations will increase our legal, accounting and financial compliance costs and will make certain corporate activities more time-consuming and costly.

We have determined during our reporting process for the fiscal year ending March 31, 2018 that there were material weaknesses in our internal controls over financial reporting as of that date. If we fail to re-establish and maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud, and investor confidence and the market price of our ADSs may be adversely impacted.

Our management conducted an evaluation of the effectiveness of internal control over financial reporting based on the framework in “Internal Control — Integrated Framework (2013)” issued by the Committee of Sponsoring Organizations of the Treadway Commission.

Under auditing standards established by the U.S. Public Company Accounting Oversight Board, a material weakness is a deficiency or combination of deficiencies in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of our annual or interim financial statements will not be prevented or detected and corrected on a timely basis. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluations of effectiveness to future periods are subject to the risk controls and may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate.  

In our assessment of internal controls as of March 31, 2018, we have determined that material weaknesses in internal controls over financial reporting that existed in the prior years have not been completely remediated at FRONTEO USA, Inc. our consolidated subsidiary in the U.S. (“FUSA”) related to the entity level controls, the financial statement closing and reporting process, revenue recognition and income taxes. We believe we have made  some improvements as a result of our remediation efforts during the year. However, the impact of the remaining material weaknesses of FUSA continues to have a negative impact on the overall financial statement close process, resulting in material weaknesses in internal controls therein at the consolidation level, specifically in the area of revenue accounting. Our inability to remediate revenue accounting controls also impacted our readiness to effectively control and execute the required adoption of ASC 2016-20,  “Technical Corrections and improvements to Topic 606, Revenue from Contracts with Customers,” for the year end. Given the aforementioned material weakness in internal controls over financial reporting which existed as of March 31, 2018, we may not be able to receive an unqualified opinion in the attestation report from the independent auditor as of March 31, 2019, and we may, therefore, not satisfy the requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002.

Our management fully recognizes the importance of design, implementation, and maintenance of internal controls related to financial reporting. We will continue to put our efforts to improve the control environment, strengthen the personnel with U.S. GAAP expertise in the accounting and finance departments of the FUSA and establish effective measures to prevent the reoccurrence of such material weaknesses. Our management has been and will continue to devote a substantial amount of time to review and implement remediation of these remaining material weaknesses. However, until this remediation is complete, we cannot assure you that it will be completed in a timely manner. Furthermore, we expect to incur additional costs in remediating the material weaknesses that exist in our internal control over financial reporting.

Undetected programming errors could harm our reputation or decrease market acceptance of our services, which would materially and adversely affect our results of operations.

Our software solutions are complex and may contain defects, errors or bugs when first introduced to the market or to a particular client, or as new versions are released. Because we cannot test for all possible scenarios, our solutions may contain errors which are not discovered until after they have been

installed, and we may not be able to timely correct these problems. These defects, errors or bugs could interrupt or delay completion of projects or sales to our clients. In addition, our reputation may be damaged and we may fail to acquire new projects from existing clients or new clients. We generally have been able to resolve such flaws and errors. However, we cannot assure you that we will be able to detect and resolve all these programming flaws and errors in a timely manner. Undetected programming errors, defects and resulting unsatisfactory customer service to clients can disrupt our operations, adversely affect the client experience, harm our reputation, or cause our clients to reduce their use of our services, any of which could materially and adversely affect our results of operations.

Our failure to protect our intellectual property rights may undermine our competitive position, and we may incur substantial costs to protect our intellectual property rights.

A substantial portion of our software solutions and systems are proprietary and we rely on statutory copyright, trademark, patent, trade secret laws, client license agreements, employee and third-party non-disclosure agreements and other methods to protect our proprietary rights. Nevertheless, these resources afford only limited protection and the actions we take to protect our intellectual property rights may not be adequate. We cannot assure you that we have secured, or will be able to secure, appropriate protections for all of our proprietary rights. In particular, third parties may infringe or misappropriate our proprietary technologies or other intellectual property rights, which could have a material adverse effect on our business, financial condition and results of operations. In addition, litigation may be necessary to enforce our intellectual property rights, protect our trade secrets or determine the validity and scope of the proprietary rights of others. The outcome of any such litigation may not be in our favor. Furthermore, any such litigation may be costly and may divert management attention as well as other resources away from our business. An adverse determination in any such litigation will impair our intellectual property rights and may harm our business, prospects and reputation. The occurrence of any of the foregoing could have a material adverse effect on our business, financial condition and results of operations.

We may be subject to infringement, misappropriation and indemnity claims in the future, which may cause us to incur significant expenses, pay substantial damages and be prevented from providing our services or technologies.

Our success depends, in part, on our ability to carry out our business without infringing the intellectual property rights of third parties. Patent and copyright law covering software-related technologies is evolving rapidly and is subject to a great deal of uncertainty. Some third party intellectual property rights may be extremely broad and it may not be possible for us to conduct our operations in such a way so as to avoid infringement of those intellectual property rights. Our proprietary or licensed technologies, processes or methods may be covered by third-party patents or copyrights, either now existing or to be issued in the future.

Third parties may raise claims against us alleging infringement or violation of their intellectual property and any such litigation may cause us to incur significant expenses. Third-party claims, if successfully asserted against us, may cause us to pay substantial damages, seek licenses from third parties, pay ongoing royalties, redesign our services or technologies, or prevent us from providing services or technologies subject to these claims. Even if we were to prevail, any litigation would likely be costly and time-consuming and divert the attention of our management and key personnel from our business operations.

If we are not able to successfully market our services to new and existing clients and to build our brand and achieve market acceptance for our solutions and services, we may not be able to maintain and expand our operations and our results may be adversely affected.

While we derive a significant portion of our revenue from a small number of substantial clients, the specific clients change from year to year, and we expect this trend to continue. The vast majority of our revenue is derived from limited scope engagements that do not include long-term commitments. Our clients use eDiscovery and forensic services, for the most part, on an “as needed basis,” when a specific legal or administrative proceeding, investigation or other legal challenge requires them to rapidly analyze and produce large amounts of digitally-formatted information. In the absence of such a demand, our clients’ demand for our services and solutions tends to be much less extensive. This means that contracts for our eDiscovery services tend to be time and subject specific. The fact that we have sold our solutions to a client in one fiscal year or quarter does not ensure on-going use by that client in any subsequent period unless a new need for our services arises.

Considering this situation, in order to expand our business, it is imperative for us to continuously market our services and solutions to existing and potential clients and to build market recognition of our capabilities and our brand so that when companies have a need for our Legal Tech Services (eDiscovery and forensic) and/or AI Solutions (business intelligence, digital communications and healthcare), we are perceived as an attractive provider. If our marketing and brand building efforts are not successful and we are not able to secure new mandates when existing contracts reach their conclusion, we may have difficulty maintaining and increasing the use of our services and our quarterly and annual results of operations could be materially adversely affected.

Our solutions incorporate and work in conjunction with third-party hardware and software products. If this hardware or software were not available to us at reasonable cost or at all, our results of operations could be adversely impacted.

Although our solutions primarily rely on our own core technologies, some of our solutions incorporate third-party hardware and software products. In addition, our solutions are designed to work in conjunction with the third-party hardware and software in our clients’ existing systems. If any third party were to discontinue making their products available to us or our clients on a timely basis, or were to increase materially the cost of their products, or if our solutions failed to properly function or interoperate with replacement hardware or software products, we may need to incur costs in finding replacement products and, if necessary, redesigning our solutions to function with or on replacement third-party products. Replacement products may not be available on terms acceptable to us or at all, and we may be unable to develop alternative solutions or redesign our solutions on a timely basis or at a reasonable cost. If any of these were to occur, our results of operations could be adversely impacted.

Future government legislation or changes in court rules could adversely affect our ability to sell our eDiscovery systems.

The delivery of our eDiscovery services is not directly regulated by the U.S. or Japanese governments. Our eDiscovery solutions and the clients we serve are, however, directly or indirectly affected by federal and state laws and regulations and court rules. For example, any amendments to the Federal Rules of Civil Procedure regarding discovery of “electronically stored information” could affect our clients, and indirectly, our ability to productively market and sell our eDiscovery solutions. Future federal or state legislation or court rules, or court interpretations of those laws and rules, could have an adverse impact on our revenues and results of operations.

Our ability to expand our operations and maintain or increase our revenue is dependent on the quality of our customer service and support services, and our failure to perform at a high level and provide high quality service could have a material adverse effect on our results of operations.

Our clients depend upon our customer service and support staff to meet their eDiscovery and forensic analysis needs. High-quality support services are critical for the success and sale of our services and solutions. If we fail to provide high-quality support on an ongoing basis, our clients may react negatively and our reputation in the marketplace could be materially and adversely affected, which would negatively impact our ability to secure contracts from existing and potential clients. Our failure to maintain high-quality support services could have a material and adverse effect on our business, results of operations and financial condition.

Our principal shareholders, directors and executive officers own a large percentage of our shares and have significant voting power, allowing them to exercise substantial influence over matters subject to shareholder approval.

Our executive officers, directors and principal shareholders holding 5% or more of our outstanding shares and their respective affiliates beneficially own 39% of our issued and outstanding voting shares. Accordingly, these executive officers, directors and principal shareholders have substantial influence over the outcome of corporate actions requiring shareholder approval, including the election of directors, any merger, consolidation or sale of all or substantially all of our assets or any other significant corporate transaction, and their interests may not align with the interests of our other shareholders. These shareholders may also delay or prevent a change of control or otherwise discourage a potential acquirer from attempting to obtain control of us, even if such a change of control would benefit our other shareholders.  

Significant movements in foreign currency exchange rates or change in monetary policy may materially harm our financial results.

Our reporting currency is the Japanese yen and our operations in other countries, including the United States, South Korea, and Taiwan, use the applicable local currency. We are subject to the effects of exchange rate fluctuations with respect to these currencies which, among other factors, may be influenced by government policies and domestic and international economic and political developments.

Any significant change in the value of the currencies of the countries in which we do business against the Japanese yen could have a material adverse effect on our financial condition and results of operations, expressed in Japanese yen.

We recognize foreign currency transaction gains and losses arising from our operations in the period incurred. As a result, currency fluctuations between the Japanese yen and the other currencies in which we do business have caused and will continue to cause foreign currency transaction and translation gains and losses, which historically have sometimes been material and could be material in future periods. We cannot predict the effects of exchange rate fluctuations upon our future operating results because of the number of currencies involved, the variability of currency exposures and the potential volatility of currency exchange rates. We do not take actions to manage our foreign currency exposure, such as entering into hedging transactions. 

Risks Related to the Ownership of Our American Depositary Shares (ADSs)

We expect that the price of our ADSs will fluctuate substantially.

The market price of our ADSs could be affected by a number of factors, including:

In the past, securities markets have experienced significant price and volume fluctuations not related to the operating performance of particular companies. Future market fluctuations may also

materially adversely affect the market price of our ADSs. In the past, following periods of volatility in the market price of a company’s securities, shareholders have often instituted securities class action litigation against that company. Any such class action suit or other securities litigation would divert the attention of our senior management, require us to incur significant expense and, whether or not adversely determined, could materially adversely affect our business, financial condition, results of operations and prospects.

Certain judgments obtained against us by holders of the ADSs may not be enforceable.

We are a company incorporated under the laws of Japan and our principal assets are located in Tokyo. In addition, all of our directors reside in jurisdictions outside of the United States and substantially all of the assets of these persons are located in those non-U.S. jurisdictions. As a result, it may not be possible to effect service of process within the United States or elsewhere upon these directors, including with respect to matters arising under the U.S. federal securities laws or applicable state securities laws. For example, Japan does not have treaties with the United States and many other countries providing for the reciprocal recognition and enforcement of judgments of courts. As a result, it may be difficult or impossible for a holder of ADS to bring an original action against us or against these individuals in a Japanese court in the event that a holder pursues a lawsuit under the U.S. federal securities laws or otherwise.

There is no statutory recognition in Japan of judgments obtained in the United States, although the courts of Japan will in certain circumstances recognize and enforce a civil, final judgment of a foreign court of competent jurisdiction without retrial on the merits. While there is no binding authority on this point, it may be difficult to enforce a civil judgment of a United States court imposing a monetary award based on the civil liability provisions of the U.S. federal securities laws.

If securities or industry analysts publish negative reports or cease to publish reports about our business, the price and trading volume of our securities could decline.

The trading market for our ADSs depends in part on the research and reports that industry or financial analysts publish about us or our business. If one or more of the analysts covering us downgrade their estimates or evaluation of our common stock, the price of the ADSs could decline. If one or more of these analysts cease coverage of our company or fail to publish reports on us regularly, we could lose visibility in the market for the ADSs, which in turn could cause the price of the ADSs or trading volume to decline or adversely affect the liquidity of the market for the ADSs.

The value of our ADSs may not perfectly track the price of our common stock.

Our common stock currently trades on the Tokyo Stock Exchange (TSE) under stock code number 2158. Active trading volume and efficient pricing for our common stock on the TSE will usually, but not necessarily, indicate similar characteristics in respect of our ADSs. In addition, the terms and conditions of our agreement with our depositary may result in less liquidity or lower market value of our ADS than for our common stock. Therefore, the trading price of our common stock may not be correlated with the price of our ADSs. In addition, since the holders of our ADSs may surrender our ADSs to take delivery of and trade our common stock (a characteristic that allows investors in ADSs to take advantage of price differentials between different markets), an illiquid market for our common stock may result in an illiquid market for our ADSs.

The right of holders of ADSs to participate in any future rights offerings may be limited, which may cause dilution to their holdings and holders of ADSs may not receive cash dividends if it is impractical to make them available to them.

We may, from time to time, distribute rights to our shareholders, including rights to acquire our securities. However, we cannot make any such rights available to our ADS holders in the United States unless we register such rights and the securities to which such rights relate under the Securities Act or an exemption from the registration requirements is available. In addition, the deposit agreement provides that the depositary bank will not make rights available to ADS holders unless the distribution to ADS holders of both the rights and any related securities are either registered under the Securities Act or exempted from registration under the Securities Act. We are under no obligation to file a registration statement with respect to any such rights or securities or to endeavor to cause such a registration statement to be declared effective. Moreover, we may not be able to establish an exemption from registration under the Securities Act. Accordingly, ADS holders may be unable to participate in our rights offerings and may experience dilution.

The depositary has agreed to pay ADS holders the cash dividends or other distributions it or the custodian receives on our common stock or other deposited securities after deducting its fees and expenses. However, because of these deductions, ADS holders may receive less, on a per share basis with respect to their ADSs than they would if they owned the number of shares or other deposited securities directly. ADS holders will receive these distributions in proportion to the number of common stock the ADSs represent. In addition, the depositary may, at its discretion, decide that it is not lawful or practical to make a distribution available to any holders of ADSs. For example, the depositary may determine that it is not practicable to distribute certain property through the mail, or that the value of certain distributions may be less than the cost of mailing them. In these cases, the depositary may decide not to distribute such property and ADS holders will not receive such distribution.

Sales of a substantial number of shares of our common stock or ADSs in the public markets by our existing shareholders could cause the price of our ADSs to fall.

Sales of a substantial number of shares of our common stock or ADSs in the public market or the perception that these sales might occur could depress the market price of the ADSs and could impair our ability to raise capital through the sale of additional equity securities. We are unable to predict the effect that any such sales may have on the prevailing market price of the ADSs.

Rights of shareholders under Japanese law may be different from those under the laws of the United States.

Our articles of incorporation, the regulations of our Board of Directors and the Companies Act govern our corporate affairs. Legal principles relating to such matters such as the validity of corporate procedures, directors’ and officers’ fiduciary duties and shareholders’ rights are different from those that would apply if we were a company incorporated in the United States. Shareholders’ rights under Japanese law are different in some significant respects from shareholders’ rights under the laws of the United States. These differences include, but are not limited to, limitations on voting shares that comprise less than one full unit of our shares, the right to participate in a demand for the convocation of a general meeting of shareholders, and the right to join with other shareholders to propose an agenda item to be addressed at a general meeting of shareholders. ADS holders may have more difficulty in asserting rights as a shareholder than they would as a shareholder of a corporation organized in the United States.

ADS holders may not have the same voting rights as the holders of our common stock and must act through the depositary to exercise their rights.

Except as described in the deposit agreement, holders of the ADSs will not be able to directly exercise voting rights attaching to the shares evidenced by the ADSs. In accordance with the terms of the deposit agreement, holders of the ADSs have the right to instruct the depositary how to vote the number of common shares represented by their ADSs. However, ADSs holders may not receive voting materials in time to instruct the depositary to vote, and it is possible that persons who hold ADSs through brokers, dealers or other third parties will not have the opportunity to exercise a right to vote. Upon our written request, the depositary will mail to ADSs holders a shareholder meeting notice which contains, among other things, a statement as to the manner in which voting instructions may be given, including an express indication that such instructions may be given or deemed given to the depositary to give a discretionary proxy to a person designated by us if no instructions are received by the depositary from ADSs holders on or before the response date established by the depositary. However, no voting instruction shall be deemed given and no such discretionary proxy shall be given with respect to any matter as to which we inform the depositary that (i) we do not wish such proxy to be given, (ii) substantial opposition exists, or (iii) such matter materially and adversely affects the rights of shareholders. We make all reasonable efforts to cause the depositary to extend voting rights to ADS holders in a timely manner, but holders may not receive the voting materials in time to ensure that they can instruct the depositary to vote. Furthermore, the depositary and its agents will not be responsible for any failure to carry out any instructions to vote or for the manner in which any vote is cast or for the effect of any such vote. As a result, ADS holders may not be able to exercise the right to vote and may lack recourse if the ADSs are not voted as requested. In addition, ADS holders are not able to call a shareholders’ meeting.

ADS holders may be subject to limitations on transfer of their ADSs.

ADSs are transferable on the books of the depositary. However, the depositary may close its transfer books at any time or from time to time when it deems expedient in connection with the

performance of its duties. In addition, the depositary may refuse to deliver, transfer or register transfers of ADSs generally when our books or the books of the depositary are closed, or at any time if we or the depositary deem it advisable to do so because of any requirement of law or of any government or governmental body, or under any provision of the deposit agreement, or for any other reason.

We are exempt from certain corporate governance requirements of Nasdaq. This may afford less protection to the holders of our ADSs.

We are exempt from certain corporate governance requirements of Nasdaq by virtue of being a “foreign private issuer” as defined in Rule 405 under the Securities Act. As a foreign private issuer, we are permitted to, and plan to, follow the practice of Japan and of the TSE, on which our common stock is listed, in lieu of certain corporate governance requirements of Nasdaq.

This means that we will be exempt from certain of Nasdaq’s corporate governance rules, including those that require:

As a result, we cannot assure holders that the compensation of our officers will be determined, or recommended to the Board of Directors for determination, by a majority of the independent directors or by a compensation committee comprised solely of independent directors. There also can be no assurance that director nominees will be selected or recommended by a majority of the independent directors or a nominating committee comprised solely of independent directors. 

Unless we no longer qualify under, or choose to no longer rely on, these exemptions in the future, holders will not have the same protections afforded to shareholders of companies that are subject to all of the Nasdaq corporate governance requirements.

We are an “emerging growth company” and our election to delay adoption of new or revised accounting standards applicable to public companies may result in our financial statements not being comparable to those of other public companies. As a result of this and other reduced disclosure and governance requirements applicable to emerging growth companies, our ADSs may be less attractive to investors.

We are a “foreign private issuer” and are not required to comply with certain periodic disclosure and current reporting requirements of the Exchange Act. In addition, we are an “emerging growth company,” as defined in the JOBS Act, and we intend to take advantage of certain exemptions from various reporting requirements that are applicable to other public companies that are not emerging growth companies including, but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute payments not previously approved. In addition, Section 107 of the JOBS Act provides that an emerging growth company can take advantage of the extended transition period provided in Section 7(a)(2)(B) of the Securities Act, for complying with new or revised accounting standards. In other words, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected to delay such adoption of new or revised accounting standards, and as a result, we may not comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. As a result of such election, our financial statements may not be comparable to the financial statements of other public companies. We cannot predict if investors will find our ADSs less attractive because we rely on these exemptions. If some investors find our ADSs less attractive as a result, there may be a less active trading market for our ADSs and the trading price of our ADSs may be more volatile. We have taken advantage of these reporting exemptions until we are no longer an “emerging growth company.” We will cease to be an “emerging growth company” for the fiscal year ending March 31, 2019, which is the fifth anniversary of our initial public offering.

U.S. holders of our ADSs or common stock may suffer adverse tax consequences if we are characterized as a Passive Foreign Investment Company for U.S. federal income tax purposes.

There is a risk that we will be classified as a “passive foreign investment company” (a “PFIC”) for U.S. federal income tax purposes. Our status as a PFIC could result in a reduction in the after-tax return to U.S. holders of our ADSs or common stock and may cause a reduction in the value of such shares. We will be classified as a PFIC for any taxable year in which (i) at least 75% of our gross income is passive income or (ii) at least 50% of the average value of all of our assets produce or are held for the production of passive income. For this purpose, passive income includes dividends, interest, and royalties and rents that are not derived in the active conduct of a trade or business, as well as gains from the sale of assets that produce passive income. Based on the composition of our income and valuation of our assets, we do not believe we were a PFIC for our most recently completed taxable year and we do not expect to be a PFIC in our current taxable year.  However, the PFIC tests are applied annually, and there is no assurance that we will not be classified as a PFIC in any particular taxable year. If we are classified as a PFIC, U.S. holders of our ADSs or common stock could be subject to greater U.S. income tax liability than might otherwise apply, imposition of U.S. income tax in advance of when tax would otherwise apply, and detailed tax filing requirements that would not otherwise apply. Subject to certain exceptions, once a U.S. holder’s shares are treated as shares in a PFIC, they remain shares in a PFIC. Dividends received by a U.S. holder from a PFIC will not constitute qualified dividend income qualifying for lower tax rates. The PFIC rules are complex, and U.S. holders of our ADSs or common stock are urged to consult their own tax advisors regarding the possible application of the PFIC rules to them in their particular circumstances. See “Taxation—United States Taxation.” U.S. holders of our ADSs or common stock may suffer adverse tax consequences if we are characterized as a Passive Foreign Investment Company for U.S. federal income tax purposes.

There is a risk that we will be classified as a “passive foreign investment company” (a “PFIC”) for U.S. federal income tax purposes. Our status as a PFIC could result in a reduction in the after-tax return to U.S. holders of our ADSs or common stock and may cause a reduction in the value of such shares. We will be classified as a PFIC for any taxable year in which (i) at least 75% of our gross income is passive income or (ii) at least 50% of the average value of all of our assets produce or are held for the production of passive income. For this purpose, passive income includes dividends, interest, and royalties and rents that are not derived in the active conduct of a trade or business, as well as gains from the sale of assets that produce passive income. Based on the composition of our income and valuation of our assets, we do not believe we were a PFIC for our most recently completed taxable year and we do not expect to be a PFIC in our current taxable year.  However, the PFIC tests are applied annually, and there is no assurance that we will not be classified as a PFIC in any particular taxable year. If we are classified as a PFIC, U.S. holders of our ADSs or common stock could be subject to greater U.S. income tax liability than might otherwise apply, imposition of U.S. income tax in advance of when tax would otherwise apply, and detailed tax filing requirements that would not otherwise apply. Subject to certain exceptions, once a U.S. holder’s shares are treated as shares in a PFIC, they remain shares in a PFIC. Dividends received by a U.S. holder from a PFIC will not constitute qualified dividend income qualifying for lower tax rates. The PFIC rules are complex, and U.S. holders of our ADSs or common stock are urged to consult their own tax advisors regarding the possible application of the PFIC rules to them in their particular circumstances. See “Taxation—United States Taxation.”

In 2010, we established Payment Card Forensics, Inc., a Japanese subsidiary with a 60% ownership interest. In 2011, we established UBIC Risk Consulting, Inc., a Japanese subsidiary with an 80% ownership interest. During that year, we also established two wholly-owned subsidiaries, UBIC Korea, Inc. and UBIC Taiwan, Inc. with offices in Seoul, South Korea and in Taipei, Taiwan, respectively, and opened an office in Reston, Virginia.

In 2012, we established UBIC Patent Partners, Inc. as our wholly-owned subsidiary in Japan. During that year, we also opened our office in New York.

In May 2013, we completed the initial public offering of our American Depositary Shares on the Nasdaq Global Market under the symbol “UBIC” (since July 1, 2016, “FTEO”) and relocated our Reston office to Washington D.C.

In August 2014, we acquired TechLaw Solutions, Inc. (“TLS”), as a wholly-owned U.S. subsidiary to expand our presence in the U.S. market for complete eDiscovery services. Headquartered in Chantilly, Virginia, TLS had a review center in New York and an operating center in Golden, Colorado. We also opened our office in Los Angeles, California during that year.

In February 2015, we acquired the remaining 20% ownership shares of UBIC Risk Consulting, Inc. and subsequently absorbed it into the Company through an absorption-type merger. In April 2015, we established UBIC Medical, Inc. as a wholly-owned subsidiary in Japan. In July 2015, we acquired EvD, Inc., (“EvD”) as a wholly-owned U.S. subsidiary to further expand our capabilities and service network. Headquartered in San Francisco, California, EvD had branch offices in New York, New York, Phoenix, Arizona, Houston, Texas, Portland, Oregon and Los Angeles, California, in addition to an operating center in Manila, Philippines. In September 2015, we established Rappa, Inc., as a wholly-owned subsidiary in Japan, and in October 2015, we merged UBIC Patent Partners, Inc. into the Company through an absorption-type merger. During that year, we opened a new review center in Washington D.C. and in February 2016, a new flagship review center in New York to further expand our review capabilities and service offerings in the U.S. and internationally.

In 2016, we launched the “FRONTEO” rebranding strategy in support of the Company’s vision and mission of creating a brighter future for its clients and society and commenced using the names to FRONTEO as our new worldwide brand, including wholly-owned subsidiaries. The word FRONTEO was derived from the word ‘FRONT’ and the Latin word ‘EO’, with a combined meaning of ‘moving forward’. FRONTEO has the experience and vision to move forward, by fully engaging and servicing our clients, driving innovation into our product development cycles, and expanding our global capabilities to continue to create deep value for clients and consumers alike. As part of the rebranding strategy and expected synergy, we have integrated the operations of our three U.S. subsidiaries, i.e., UNA, EvD and TLS, whereby UNA was merged into and with EvD, and TLS became a wholly-owned subsidiary of EvD, primarily responsible for government contracts.  Effective July 1, 2016, the names of UBIC and its group companies were changed as follows:

We integrated our eDiscovery services, products and client support under the FRONTEO brand to amplify the Company’s global leadership role in the delivery of legal technology, litigation support services, Business Intelligence (“BI”) applications and Artificial Intelligence (“AI”) solutions. The newly unified FRONTEO is well positioned as a leading provider of comprehensive services across the eDiscovery spectrum, as well as in other vertical markets leveraging its AI platform:

In August 2016, we established FRONTEO EMEA, Ltd. as a wholly-owned subsidiary of FRONTEO USA, Inc. (formerly EvD) in London, England to expand our service offerings in European market, and in November 2016, we acquired the business of Essential Discovery, Inc. (“EDI”), a boutique eDiscovery firm with specialization in document reviews with Fortune 250 corporations and AM Law 100 clients. We believe that EDI is a strategic fit into the expansive network that FRONTEO already has in place.

We apply our capital expenditures primarily to develop new eDiscovery technologies, to improve the delivery of services and to expand global operating capabilities as well as to promote AI technologies by focusing on client needs in each market we serve. Our capital expenditures were ¥1,125.8 million, ¥1,369.5 million and ¥800.4 million in fiscal years ended March 31, 2016, 2017 and 2018, respectively.

Corporate Information

Our executive offices are located at Meisan Takahama Building, 2-12-23, Konan, Minato-ku, Tokyo, Japan and our telephone number is: +81 (3) 5463-6344. Our corporate website is http://www.fronteo.com/global/. Our agent for service of process in the U.S. is FRONTEO USA, Inc., 1115 Broadway, New York, NY 10010.

4.B.      BUSINESS OVERVIEW

Overview

We are a leading provider of Asian-language eDiscovery solutions and services. We have extensive eDiscovery and forensic experience and expertise with information documented in Japanese, Korean, Chinese and English, and we apply this expertise in connection with litigation, administrative proceedings and investigations. Our clients include leading law firms, corporate legal departments and government agencies. While we serve these clients from our offices in Japan, the United States, South Korea and Taiwan, we have been expanding our resources through mergers and acquisitions in the biggest market, the U.S. Thus, our revenue in the U.S. has increased and now constitutes approximately 50% of our consolidated group revenue. In addition, based on our expertise in the legal business, we have developed our own Artificial Intelligence (AI) engine, KIBIT. It not only adds a competitive edge in our existing business, but also has become a driver for recent expansion into new areas, such as digital marketing, healthcare and business intelligence.

In our eDiscovery solutions business, we assist clients involved in cross-border litigation, administrative proceedings and internal investigations, including those related to antitrust investigations, intellectual property (IP) litigation, the Foreign Corrupt Practices Act (FCPA) and product liability (PL) investigations. The particular matters in which we are engaged by clients typically involve Asian language information. A particular challenge of eDiscovery involving Asian-language information is the accurate electronic recognition of Japanese, Korean and Chinese characters and the organization of the collected information in a format that can be effectively and efficiently reviewed and identified as relevant to the particular investigation. For example, when most conventional eDiscovery technologies are applied to Asian language content, the result is garbled text or otherwise inaccurate outputs. We believe our proprietary Lit i View eDiscovery solution accurately handles Asian-language characters, encoding schemes and native file systems. Lit i View also streamlines and consolidates our and our clients’ workflows. Our Intelligence Cloud formerly known as Legal Cloud hosting solution complements and interfaces with Lit i View and helps to address the substantial complexity and cost associated with these international investigations and litigations. Because of the flexible, comprehensive and integrated nature of our solutions, we can address the entire electronic discovery reference model (EDRM) life-cycle in connection with these matters, which we believe enables us to optimize outcomes and provide significant cost savings to our clients.

We have assisted clients in more than 7,000 administrative and legal proceedings in the United States, including Department of Justice (DOJ), International Trade Commission (ITC) and Securities and Exchange Commission (SEC) investigations, and more than 1,200 corporate investigations in Japan, South Korea, China and Singapore.

The artificial intelligence (AI) market is rising rapidly. In June 2017, the Cabinet announced a strategic initiative titled “Future Investment Strategy 2017,” which is a full-scale social implementation of innovative technologies such as IoT (Internet of Things) and AI in order to achieve medium- to long-term growth for Japan. In addition, various examples that demonstrate the effect of AI are being mentioned frequently as a way to solve social issues such as labor population decrease, long work hours and business process improvement. As a front runner that has been implementing AI in business settings, the Company will further strive to develop the AI market in three fields: business intelligence, digital communication and healthcare.

Industry Overview

eDiscovery solutions enable organizations to identify, preserve, collect, process, review, analyze and produce data in order to meet compliance, records management and/or legal discovery requirements. Data that can be subject to investigation include texts, email, calendar files, images, databases, video, audio files, web sites, spreadsheets and computer programs. In addition, the forms of data storage are not limited to servers, hard disks or other data storage media but can take various forms, including smartphones and tablets, and they are diversifying with the advancement of technology. The volume of such electronically stored information (ESI) is continuing to grow at an extraordinary rate. According to the RAND Corporation, the majority of Fortune 1000 corporations now spend an estimated US$5 million to US$10 million annually on discovery. Moreover, by 2020, it is expected that the data created and copied annually will reach approximately 50 zetta bytes (50 trillion giga bytes), further generating need for e-discovery solutions. While email remains the primary application driving eDiscovery growth, it is expected that there will be dramatic growth being driven by explosively increasing data due to social networking and cloud computing.

According to the latest analysis about eDiscovery market by Mordor Intelligence, the global eDiscovery market, in both services and software, is forecasted to grow from US$11,521.0 million to US$19,729.0 million by 2023 at a CAGR of 9.5% from 2017 to 2023. Mordor Intelligence’s analysis includes several reasons for the projected growth, including increases in ESI volume, the continued domination of ESI in legal proceedings thanks to reliance on electronic communications and records, regulatory requirements for archiving electronic information for compliance purposes, and the emergence of social media as a source of evidence in civil litigation through its inclusion in eDiscovery.

eDiscovery is fundamentally different from paper-based evidence discovery primarily because of the much higher volume of electronic information produced and maintained by businesses and other organizations. For example, enterprise information stored in one personal computer is equivalent to an estimated four to six thousand boxes of printed material. In addition, a growing number of corporations have recently introduced mobile terminals and SNS into their operations. Because of the sheer volume of information that must be analyzed in investigations or other legal matters, it is extremely challenging to investigate archives of electronic information manually. Accordingly, in order to achieve success in a lawsuit and avoid sanctions, we believe that attorneys must employ an automated process to analyze this trove of information, identifying and producing only information relevant to the matter. Providing only relevant documents is a very important consideration for organizations, which generally prefer to keep confidential those documents and other materials they are not legally required to produce.

The majority of eDiscovery solutions deployed are in response to a specific investigation or lawsuit; however, there are a growing number of proactive enterprises that are deploying eDiscovery solutions to provide better readiness and ongoing protection against potential legal issues. In addition, some enterprises have begun to show more interest in cloud-based eDiscovery services. While historically most organizations have tended to prefer deployment of eDiscovery solutions on-site, greater recognition of the benefits of cloud-based solutions together with diminishing concerns regarding data safety and accessibility have contributed to wider adoption of cloud-based solutions.

The various stages of the eDiscovery process are referred to as the electronic discovery reference model (EDRM) and are set forth below:

Many eDiscovery solution providers do not offer end-to-end coverage of the EDRM, and instead focus on one or more of identification, preservation, collection, and processing, review and analysis of data. Other eDiscovery solution providers are able to offer end-to-end coverage of the EDRM, either on their own or by utilizing technology partnerships to offer full coverage of all phases of the EDRM.

Our clients use eDiscovery and forensic services, for the most part, on an “as needed basis,” when a specific legal or administrative proceeding, investigation or other legal challenge requires them to rapidly analyze and produce large amounts of digitally-formatted information. In the absence of such a demand, a company’s demand for eDiscovery services and solutions tends to be much less extensive. This means that contracts for eDiscovery services tend to be time and subject specific. The fact that we have sold our eDiscovery solutions to a client in one fiscal year or quarter does not ensure on-going use by that client in any subsequent period, unless a new need for our services arises.

In light of this situation, in order to expand our business, it is imperative for us to continuously market our services and solutions to existing and potential clients and to build market recognition of our capabilities and our brand so that when companies have a need for eDiscovery and forensic services, we and our solutions are perceived as an attractive provider. In addition, to the extent that, as discussed above, we are able to expand our client base among non-Asian law firms since we believe that they will need our services to review Asian-language materials. We believe that this will expand our revenue base.

The overall market for eDiscovery and forensic services has benefited from the growing volume of ESI and a rapid increase in the number of lawsuits filed and investigations commenced in the United States which involve patents, intellectual property, product safety, price cartels, the U.S. Foreign Corrupt Practices Act and other issues. Our financial performance has also benefited from this trend, due mainly to lawsuits filed and investigations commenced in the United States against not only U.S. companies but also Japanese and other Asian multinational corporations. Recently, we have also benefited more from engagements for large and midsize international government investigations. Our financial performance is more likely to be driven by increasing lawsuits and investigations involving Asian companies or U.S. companies with Asian operations, and by building out our sales and marketing presence and increasing our brand awareness and capabilities in the United States.

While the eDiscovery market is forecast to grow at a CAGR of 9.5% from 2017 to 2023, the highest growth is expected in the off-premise, or “cloud,” software market and its CAGR is forecast at 10.1%. We provide a one-stop, cloud-based eDiscovery solution with AI-based software that saves cost and time significantly. As our solutions demonstrate their value in the market place, we anticipate that they will provide a basis for our expanded and durable growth of total revenues and improved operating income and net income in the future.

The artificial intelligence (AI) market is rising rapidly. As a front runner that has been implementing the AI in business settings, the Company will further strive to develop the AI market in three fields: business intelligence, digital communication and healthcare.  

i) Business Intelligence

In the Business Intelligence field, the Company is working on sales of software such as “KIBIT Email Auditor”, “KIBIT Patent Explorer (patent search and analysis system)”, and “KIBIT Knowledge Probe (Kibit Knowledge Probe) ” while providing implementation support and data analysis.

ii) Digital Communications

The Company is developing and selling “Kibiro”, a communication robot equipped with original artificial intelligence (AI) “KIBIT” and providing solutions related to digital communication using artificial “KIBIT”.

iii) Healthcare

In the healthcare field, by utilizing “Concept Encoder”, an AI engine developed independently for the purpose of promoting the utilization of healthcare related big data, FRONTEO Healthcare, Inc. (“FRONTEO Healthcare”), a subsidiary established to focus on support of medical institutions and private companies, develops and sells software and systems that support business improvement at medical sites and equipment that supports doctor's diagnosis.

Challenges in eDiscovery

In April 2006, the United States Supreme Court approved certain amendments to the Federal Rules of Civil Procedure (FRCP) regarding the discovery in litigation of certain ESI. These amendments have placed a substantial burden on organizations to produce ESI in a very limited time period. Additionally, given the fact that complying with such discovery requests may cost in excess of $1.0 million or more for a single matter and multinational corporations may be involved in dozens of such lawsuits at any given time, organizations are seeking to contain the escalating costs of such discovery.

In recent years, the amount of data created by companies which may be deemed ESI has increased greatly and is expected to continue to grow in the future. Because the cost of eDiscovery is generally proportional to the volume of data to be collected, processed, reviewed and produced for litigation, costs for this function are rising. The problem is compounded if plaintiffs’ lawyers deliberately request discovery in such a broad a manner so as to impose prohibitive eDiscovery costs, in the hope that many organizations will simply prefer to settle than incur such costs. In addition, there has also been a dramatic increase in overall eDiscovery cost in situations where data needs to be collected overseas, searched, reviewed, produced in a foreign language and translated by bi-lingual attorneys and paralegals.  

Because compliance with even the most basic eDiscovery request is expensive, organizations need to identify the appropriate technology and service providers in order to reduce costs and stay within their budget. The overall cost of eDiscovery is directly related to the number of documents to be reviewed for relevance and privilege. The overall cost of eDiscovery can be dramatically reduced if the right technology is used to conduct automated first level review before the more costly human review of such information. The skill and experience to select appropriate keywords while searching electronic documents and usage of a forensic lab capable of processing and sorting a huge amount of electronic data safely are crucial. In addition to managing costs, organizations need to utilize products and solutions that limit the eDiscovery production to disclosure of information that is relevant and responsive to the eDiscovery request, thereby reducing disclosure and leakage of valuable information that is not germane to the lawsuit.

Our Competitive Advantages

We have designed our products and services to provide comprehensive solutions to meet the challenges of managing eDiscovery and electronic data forensic investigations. The principal ways in which our solutions address these challenges include:

Business Strategy

As a leading eDiscovery company in Asia, we have developed our own eDiscovery software, Lit i View which supports Asian languages (Japanese, Chinese and Korean), and provides one-stop solutions with the highest levels of technology and know-how to analyze and process ESI for litigation.

With an established foundation for the eDiscovery legal business, we now believe that we are entering a new period of growth. Meanwhile, we are also in the process of launching new business lines using AI. We are dedicated to continued growth on a Company-wide basis to achieve our goals with a focus on the following:

The Company reorganized its business activities in order to enhance the management of cross-border transactions in FY2018. The Company has integrated each resources and operation system by business category--Legal Tech services and AI Solutions services. Accordingly, the Company’s s reportable segments have changed.

The Company’s Legal Tech service operations in Japan, the U.S. and Asia, and AI Solutions based service in Japan and Asia have been identified as the two operating segments of the Company. The Company’s chief executive officer, who is also the Company’s chief operating decision maker, regularly reviews the performance of the two operating segments and makes decisions regarding allocation of resources. The Company’s chief operating decision maker utilizes various measurements which include revenues, operating income or loss and segment assets to assess segment performance and allocate resources to segments.

Expansion of Existing Legal Business in the United States

We will continue to seek to expand and optimize our existing United States legal business operations after the acquisition of TLS, EvD, and EDI. The Company will seek to expand its U.S.-based business by streamlining operations of its U.S. subsidiaries and acquiring large-scale projects from Asian and North American companies.

We will also aim to boost sales in the review services using Lit i View, eDiscovery support software equipped with predictive coding, powered by the Company’s unique AI technology.

Development of the Information Analysis Business Leveraging AI Technology

We have been expanding the provision of solutions in the fields of healthcare, digital marketing, and business intelligence, utilizing the Company’s unique artificial intelligence technology, “KIBIT.” In each of these three fields, we plan to continue to advance the development of our products and our suite of services, including continuous analysis support and intensified consulting. We also plan to proactively recruit talented personnel to help complement our technological developments.

Enhancements to implement business strategies

We will control regional business activities through our headquarters in Japan, while providing more authority to country managers to strengthen the autonomy and unique qualities of each region. Through a centralized administrative framework, along with the development and implementation of unique business strategies in each country, we aim to build global management systems suited for improving and expanding our business operations.

Our Solutions and Services

We have reorganized business activities to better manage cross-border transactions in the fiscal year ended March 31, 2018. As a result, we have changed the structure of our business operations into two divisions: Legal Tech  business and AI Solutions business. Legal Tech business consists of eDiscovery Services and Forensic Services. AI Solutions business consists of Business Intelligence, Digital Communications and Healthcare.

Legal Tech Business

eDiscovery Services

Our eDiscovery services help our clients employ a series of scientific investigation methods that conduct evidence preservation and investigation analysis for incident response or litigation, as well as research to detect falsification and damage of electronic data. eDiscovery services can also retroactively identify acts which result in unauthorized use of computer or network resources, service obstruction, and unintentional disclosure of information. In addition, our eDiscovery services provide the preservation, processing, review and production of ESI. Our solutions (i) copy electronic data from personal computers, servers, mobile devices, website and various types of storage, (ii) search and identify relevant documents and evidence with TAR driven by KIBIT technology, our AI technology, (iii) permit the inspection of evidence and on-line hosting for review and translation, and (iv) produce the final disclosure of evidence in the court-requested format. All of our services can be provided seamlessly in the same secured environment, providing a one-stop shop for our customers.

In civil lawsuits, the plaintiff and the defendant disclose evidence before commencement of the trial. Pursuant to the Federal Rules of Civil Procedure in the United States, disclosure of electronic evidence in electronic format through “eDiscovery” has been mandated, and more than 90% of enterprise information is typically stored in electronic format. Our eDiscovery services help to ensure secure and effective information disclosure.

Lit i View, our online eDiscovery software powered by KIBIT, makes it possible for corporate customers and outside counsel to more efficiently review electronic evidence. Lit i View is designed to ensure that only necessary information is disclosed through a disclosure approval process undertaken by assigned lawyers. The inherent risk of information leakage in an eDiscovery process is a concern for enterprises. Using Lit i View, only those files identified as containing evidence are hosted to our inspection servers, and the remainder of the information is stored in our local secure data centers at many places in the world to ensure the safety and confidentiality of critical data.

We believe that we are the only eDiscovery service provider with data processing centers not only in the United States but also in Japan, South Korea, Taiwan and Philippines, and thus we can conduct the entire process of eDiscovery in Asia. This allows us to avoid sending non-responsive electronic data to other parties abroad and potentially making such confidential and proprietary data subject to the jurisdiction of the courts in other countries.

Though typically more than 90% of enterprise data is available in electronic formats, the volume of paper documents may also be significant. We perform paper based evidence discovery by scanning and subsequently digitizing documents utilizing Optical Character Recognition (OCR) techniques. We utilize methods to avoid loss of potentially responsive evidence. Once available in digital formats, the techniques followed for analysis of these documents follows identical methods employed for ESI.

Our advanced technology platform, Lit i View, is an innovative eDiscovery solution that accurately handles Asian-language characters, encoding schemes and native file systems. Developed entirely in-house at FRONTEO, Lit i View incorporates processing and filtering software specifically for Asian encoding schemes and language sets as well as for information stored in English. Lit i View allows the enterprise or its legal advisors to work efficiently and effectively by handling Chinese, Japanese and Korean as well as English information conveniently at a remote location or on-site in the enterprise offices.

We believe Lit i View more accurately identifies Asian characters and documents responsive to the eDiscovery search than competing products, and thus enables us to reduce the number of documents that need to be

handled and reviewed by persons and reduces the chances to fail to identify an important document. Lit i View works seamlessly with more than 20 software applications, including Microsoft Outlook and several unique email applications, and thus we are able to produce documents without garbled text and also capture responsive documents that would be missed by many of our competitors.

Lit i View incorporates KIBIT language capabilities such as “concept search,” which searches not only words, but also general concepts, similar meanings and relevant categorizations. Searches conducted in Asian languages are more difficult because Asian languages typically contain no spaces between words. In addition, because there are numerous ways to express different words and their combinations, keyword searches are usually insufficient to find all relevant documents. Lit i View’s use of concept searches can be very useful because users can take a case-by-case approach to determine what will be the most effective search tools.

Lit i View also permits the extracted data to be reviewed simultaneously by our reviewers, clients, and the clients’ law firm or legal team. We believe this facilitates faster and more accurate analysis of the produced data.

Our customizable Intelligence Cloud solution addresses the problem of rising costs associated with the growth and dispersion of ESI volumes across the globe, along with prolonged investigations and litigations. Because large enterprises are generating electronic data at a rapid rate, there are a growing number of proactive enterprises that are seeking to deploy data hosting solutions to provide better readiness and ongoing protection against potential eDiscovery issues. Some enterprises have begun to show increasing interest in cloud-based data hosting. While historically most organizations have tended to prefer to host data on-site in local servers, concerns regarding data preservation, confidentiality and accessibility of cloud-based services have begun to diminish. In addition to moving data into the cloud in connection with a specific investigation or lawsuit, enterprises are choosing to host data in a medium that allows for rapid preservation, collection, processing and review.

We believe that the competing cloud hosting services available are not experienced and capable of hosting the large volume of data produced by litigation. Because competing cloud hosting services typically handle a more limited amount of data, their cost structure is not conducive to handling the large volume of data produced by litigation. As a result, we are more experienced in handling large volumes of data in connection with our eDiscovery solutions, and we are both equipped and experienced in dealing with these materials and are able to host litigation data in a cost-efficient manner. Our Intelligence Cloud solution allows us to maintain client data during and after a particular litigation or investigation and maintain the data and documents in a relational database of our clients’ data and documents, along with all of the tagging and coding that was completed in connection with such project. We believe that the analysis and indexing we conduct in order to build a relational database provides a superior and distinct data hosting solution for our clients by allowing them to more rapidly access relevant data and documents for future litigations, investigations and other corporate needs.

Forensic Services

Our electronic data forensic investigation solutions and services enable the preservation, analysis, processing and production of ESI in connection with fraud and corporate information leakage. We work with a large number of enterprises and their law firms to investigate corporate violations, such as leakage of sensitive information or illegal trading, handle them in a timely manner and in accordance with relevant laws, and provide objective analysis to the stakeholders. We also perform due diligence investigations in connection with corporate mergers and acquisitions as well as new business investments that require accurate assessment of the target company or market.

In most instances of evidence gathering and analysis, solutions emerge by making proper inferences from detailed information. Often such information may not be clearly visible or even readily identifiable or available within the enterprise. Meticulously sifting through digital data by employing computer forensics enhances an enterprise’s ability to infer intelligently and make evidence gathering more efficient.

Enterprises today consider compliance and corporate social responsibility measures as important steps in building accountability, implementing crisis management systems, and improving risk mitigation processes. Based on extensive litigation support experience, we help clients create document management procedures, conduct corporate risk audits, and comply with legal requirements to provide information to relevant stakeholders.

Storage of enterprise information in electronic format raises the risk of corporate fraud and information leakage. Putting preventive processes in place is therefore an important corporate objective. Unlike measures such as forensic analysis, which are performed after a fraud has been detected, corporate risk audit is a defensive strategy against fraud before it happens. We institute regular corporate risk audit mechanisms for identifying and monitoring the flow of confidential enterprise information out of the company by departing employees.

Besides computer forensic investigation for our clients, we also sell the necessary hardware and software. We offer Lit i View XAMINER, our new KIBIT-installed digital forensic software. We also offer other forensic tools to deal with our clients’ computer forensic related needs, such as acquisition of proof, data analysis, establishment or the provision of a forensic laboratory, in addition to imported litigation infrastructure from international vendors.

Successful computer forensics entails practical knowledge and relevant skills. For clients conducting the process themselves, training is essential. We make available continuous training for conducting computer forensics. We provide training to employees of law enforcement and military agencies, employees of public enterprises, and other investigation experts that take part in various investigations in the United States and Europe and are leaders in the field of computer forensics. Our investigation specialists, whose acquired capability meets international standards, offer world class training to such investigators in Japan to help them achieve their goals.

AI Solutions Business

Business Intelligence  

The introduction of products installed with KIBIT, that can work with even the slightest volume of learning data, supports various business scenarios. An extremely small amount of time, effort and data is required for the introduction and analysis results are presented in a short period of time. 

KIBIT Patent Explorer is an AI-based patent search and analysis system that employs a unique approach to quickly and accurately find the patent-related documents that the user is looking for.

KIBIT Knowledge Probe is an AI-based business data analysis support system. Having learned the tacit knowledge of customers, the AI analyzes communications and supports the users in creating business opportunities and avoiding risk.

KIBIT Email Auditor is an automated email audit system using AI. It contributes to efforts to quickly detect and prevent the recurrence of employee wrongdoing by accumulating knowhow from the results of reviews conducted in such activities as financial audits, in-house investigations and litigation management. This helps to develop an effective compliance system.

Digital Communications

Tasks where a large volume of data expressed in natural language is involved, such as sorting/matching of information in highly specialized fields, require judgment and processing by professionals with knowledge and experience as well as experts in the relevant field. The KIBIT AI studies and replicates judgments of engaged professionals to help improve a broad range of tasks. In addition, Kibiro, a communication robot equipped with KIBIT, is capable of carrying out communication on behalf of people at reception desks, shops and facilities where people tend to gather, contributing to operational efficiency and customer satisfaction improvements. At home, it can serve as a life partner.  

Healthcare

We have found that AI technologies utilized in the legal field have a strong affinity with information management and analysis needs in medical settings. By utilizing KIBIT, which learns the tacit knowledge of human experts from a small amount of data and replicates their judgments against unknown data, we contribute to solving issues presented in the medical field such as diagnosis support, healthcare operation support, pharmaceutical industry support and healthcare information support.

Precision Medicine AI system, currently under development, uses the KIBIT AI engine to enable anyone to access the latest and most appropriate information. It helps to mitigate the challenges faced by medical professionals by dealing with the enormous mass of medical reports and papers with explanations that are consistent with a given patient’s level of understanding.

A system to mitigate patients’ risk of falling, currently under development, records symptoms which are regarded as potential signs of a patient’s risk of falling in an electronic medical record and scores them. It supports decisions on care plans by identifying patients with a high risk of falling.

Through Pharmacovigilance support (PV, Side effects report), with the KIBIT AI identifying cases of adverse side effects through analysis of text data in the reports, pharmaceutical companies are provided with support to enhance accuracy of medicinal monitoring and pharmacovigilance tasks and improve efficiency.

Clients

We provide solutions and services to enterprises, government agencies, law firms and other organizations in the United States, Europe and Asia. Since our inception, approximately 800 clients have purchased our solutions and services. Our target markets are not confined to certain industries as we are focused on providing eDiscovery and electronic data forensics solutions and services that meet the needs of any organization. We have historically focused our efforts on organizations that utilize Asian-language characters, encoding schemes and native file systems. Our clients that represented more than approximately 10% of total revenue during one or more of the last three fiscal years include TMI Associates. Because we are retained by these clients for specific projects as they arise, we expect that we will have different major clients from year to year.

Sales and Marketing

Our sales executives market solutions and services directly to prospective clients and through referral from law firms through on-site sales calls and longstanding relationships. We focus on attracting and retaining clients by providing superior integrated technology solutions and exceptional client service. Our client support specialists are responsible for providing ongoing support services for existing clients.

Our marketing efforts and lead generation activities consist primarily of client referrals, telemarketing, trade shows, industry events and press releases. Additionally, we maintain a website that clients and potential clients may access to obtain additional information related to solutions we offer. We believe that our hosting of educational seminars with respect to eDiscovery topics for legal professionals has been very beneficial to brand awareness and sales and marketing efforts generally.

Sales by Market and Segment

Operating segments are defined as components of the Company that engage in business activities from which the Company earns revenues and incurs expenses and for which separate financial information is available that is evaluated regularly by the chief operation decision-maker in deciding how to allocate resources and in assessing performance. The Company provides a variety of eDiscovery and forensic services (“Legal Tech services”) which are provided by FRONTEO and its domestic subsidiaries for domestic (Japanese) clients, by FRONTEO USA, Inc. (formerly UBIC North America, Inc. and EvD, Inc.) and FRONTEO Government Services, Inc. (formerly TechLaw Solutions, Inc.), U.S. based wholly-owned subsidiaries of FRONTEO, for clients based in the U.S. or represented by U.S.-based attorneys who  use the services of FRONTEO USA, Inc. and FRONTEO Government Services, Inc., and by FRONTEO KOREA Inc. and FRONTEO TAIWAN Inc. for clients based in Asia other than Japan. FRONTEO and its domestic subsidiaries, FRONTEO KOREA Inc. and FRONTEO TAIWAN Inc. also provide AI-based business services in the data marketing industry.

The Company reorganized its business activities to enhance the management of cross-border transactions in fiscal year ended March 31, 2018. The Company’s resources and operation systems are now organized into two operating segments -- Legal Tech business and AI Solutions business. Accordingly, the Company’s reportable segments  changed and are the same as its operating segments. The following corresponding information for the prior year was restated based on the change in reportable segments.

The Company’s Legal Tech business operations in Japan, the U.S. and Asia, and AI Solutions business in Japan and Asia have been identified as the two operating segments of the Company. The Company’s chief executive officer, who is also the Company’s chief operating decision-maker, regularly reviews the performance of the two operating segments and makes decisions regarding allocation of resources. The Company’s chief operating decision-maker utilizes various measurements, which include revenues, operating income or loss and segment assets to assess segment performance and allocate resources to segments.

The AI Solutions business in Japan has met a quantitative threshold for the year ended March 31, 2017 and the segment data for the year ended March 31, 2016 were presented for comparative purposes.

Each business within the Legal Tech segment recognizes revenue for which the segment has direct contractual relationships with its clients. Most of the Company’s clients are either corporate clients in Asia or U.S. -based law firms representing corporate clients in Asia. If the Company’s Legal Tech services are contracted between

a law firm in the U.S. and FRONTEO USA, Inc. or FRONTEO Government Services, Inc., revenue is recorded by the U.S. segment although the end corporate client may be located in areas other than the U.S.

The Company’s reportable segments are the same as its operating segments.

Seasonality

Our clients use eDiscovery and forensic services, for the most part, on an “as needed basis,” when a specific legal or administrative proceeding, investigation or other legal challenge requires them to rapidly analyze and produce large amounts of digitally-formatted information. In the absence of such a demand, a company’s demand for eDiscovery services and solutions tends to be much less extensive. This means that contracts for our services tend to be time- and subject-specific. The fact that we have sold our solutions to a client in one fiscal year or quarter does not ensure on-going use by that client in any subsequent period, unless a new need for our services arises.

Research and Development

Our development efforts in AI technology were initially focused on the niche, big-data field of cross-border litigation support, but with the creation of our KIBIT, we now have the capability to analyze various types of big data. Our research is focused on addressing two key questions: how to identify information that is important to our clients from big data, particularly information about people’s intentions and behavior, and how to effectively use the advanced knowledge of experts to analyze vast volumes of information. We are currently working to dramatically improve the quality of human intellectual activity through research that taps the knowledge of experts.

Our basic R&D policies and priorities are as follows:

Intellectual Property

We are strong believers in intellectual property, attaching the same level of importance to our intellectual property strategy as the Company does to its technology and business strategies. We believe that a strong intellectual property strategy is vital for achieving our goal of growth and expansion through the data analysis business. We look at ways of developing new types of technology, while simultaneously searching for ways to make those new technologies commercially viable. The goal of our intellectual property strategy is to find ways of protecting and strengthening those technologies, which means securing intellectual property rights so as to be able to apply their versatility to future products. Our intellectual property strategy has focused on protecting our proprietary technologies and on maintaining our competitive advantage over our rivals by building close relationships between our research centers, our clients and the market to accurately identify future business opportunities. Mirroring our business growth, our intellectual assets have expanded rapidly — quantitatively and qualitatively — and we have secured intellectual property rights not only in Japan, but also in the U.S. and other countries.

As of July 1, 2018, in Japan, we have applied for patents for 68 inventions and have been granted patents on 60 of them and in the United States, we have applied for patents for 37 inventions and have been granted patents on 13 of them. Moreover, many trademarks have been registered in many countries across the world, including “FRONTEO,” “KIBIT,” “Lit i View,” and “Landscaping,” as brands representing the uniqueness of the above technologies

To provide certain eDiscovery services to our clients, we have license agreements with software suppliers.

Competition

The eDiscovery and digital forensics solutions and services markets in the United States and Asia are intensely competitive, highly fragmented and characterized by rapidly changing technology, frequent solution introductions, changes in client demands and evolving industry standards. Moreover, realignment of markets in the United States and Asia have been active in the past few years while competitors vary in size, scope and breadth of solutions and services offered. Competitors include Guidance Software Inc., HP Autonomy Corporation plc, IBM Corporation, Symantec Corporation, EMC Corporation, Epiq, Catalyst, Access Data Group, FTI Consulting, Inc., Xerox Corporation, Navigant Consulting, Inc., Hewlett-Packard Development Company. L. P., Integreon, Inc., Merrill Corporation, Transperfect, KPMG, KLDiscovery, Inc., and Consolio.

Many of our primary competitors have longer operating histories and substantially greater financial, technical, sales, marketing and other resources than we do, as well as greater name recognition and broader solution offerings. These competitors can devote greater resources to the development, promotion, sale and support of their solutions than we can.

In addition to the competitors mentioned above, certain law firms, accounting firms, management consultant firms, turnaround specialists, and crisis management firms offer solutions and services that compete with our solutions and services.

We believe the principal competitive factors in the eDiscovery and electronic data forensics solutions and services markets include:

Although many of our competitors have greater resources and greater name recognition, we believe we compete favorably on the basis of the other competitive factors listed above. We believe our solutions and services, supported by our AI technology based on tacit knowledge, enable a process that permits the automated identification of relevant text in Asian languages, thus improving accuracy, reducing the number of steps in the review process and generating significant savings in time and cost of document review. Specifically, we believe that our predictive coding solution powered by our AI technology allows us to accurately handle English- and Asian-language characters, encoding schemes and native file systems, and provides us with a significant competitive advantage over our competition, including those with greater financial resources, a higher level of name recognition and broader solution offerings.

Government Regulation

The eDiscovery industry, solutions and services are not directly regulated by any governmental authorities. However, our clients must comply with certain governmental and judicial requirements. Class action and mass tort cases, as well as eDiscovery requirements related to litigation, are subject to various federal and state laws, as well as rules of evidence and rules of procedure established by the courts.

For example, in April 2006, the United States Supreme Court approved certain amendments to the Federal Rules of Civil Procedure regarding the discovery in litigation of certain electronically stored information. These amendments became effective on December 1, 2006. Among other things, these amendments (i) require early attention by parties in litigation to meet and confer regarding discovery issues and to develop a discovery plan that identifies and addresses the parties’ electronically stored information, (ii) expand the reach of federal court subpoenas to include electronically stored information, (iii) allow for parties to object to production of electronically stored information that is not reasonably accessible due to the undue burden or cost associated with such retrieval, and (iv) provide a “safe harbor” to parties unable to provide electronically stored information lost or destroyed as a result of the routine, good-faith operation of an electronic information system.

While these federal rules do not apply in state court proceedings, the civil procedure rules of many states have been closely modeled on these provisions. We anticipate the federal and state court discovery rules relating to electronic documents and information will continue to evolve and affect the way we develop and implement technology and service solutions to those changing discovery rules.