FSA Newsletter October 2006

The law for amending the Securities and Exchange Law and other financial laws (2006 Law No.65) and the law for abolishing and amending the related laws to implement the law for amending the Securities and Exchange Law and other financial laws (2006 Law No.66) were promulgated on June 14, following the approval and passage of the respective bills at the 164th Diet session held on June 7, 2006.
More specifically, the legislations can broadly be divided into the following four basic elements:

(1) Development of a cross-sectoral legal system to protect investors regarding financial instruments with strong investment characteristics (legal system based on so-called ''Investment Services Law'');
(2) Enhancement of the disclosure system;
(3) Reinforcement of self-regulatory functions of stock exchanges; and
(4) Strict approach to unfair trading, etc.

Part 1 reviewed the following subjects in ''1. Building a Cross-sectoral Legal System to Protect Investors regarding Financial Instruments with Strong Investment Characteristics (Legislation ''Investment Services Law'')'':

1) Transition from Securities and Exchange Law to Financial Instruments and Exchange Law;
2) Expansion of scope of regulated products;
3) Regulated cross-sectoral operations; and
4) Relaxation of restrictions on market entry according to nature of operations.

This part also reviews ''1. Building a Cross-sectoral Legal System to Protect Investors regarding Financial Instruments with Strong Investment Characteristics (Legislation ''Investment Services Law'')''.
* The Securities Exchange Law and the Financial Instruments and Exchange Law are hereinafter referred to as ''SEL'' and ''FIEL'', respectively.

1. Building a Cross-sectoral Legal System to Protect Investors regarding Financial Instruments with Strong Investment Characteristics (Legislation ''Investment Services Law'') (Continued)

5) Reorganizing regulation on conduct of financial instruments business
The FIEL stipulates many rules of conduct for financial instruments firms primarily for the purpose of investor protection.
a) Rules of Conduct relating to ''Sales and Solicitation''
Financial instruments firms should comply with the following rules in conducting ''sales and solicitation'' for securities and derivative transactions.

Regulation of advertisements, etc. (Article 37)	- Indicate that the advertiser is a financial instruments firm and the registration number. - Concerning profit prospects, an advertisement should not make claim that differ significantly from the truth or in a way that may mislead people.
Obligation to issue documents before signing contract (Article 37-3)	- Indication that the firm is a financial instruments firm, and the registration number. - Outline of contract, brief description of fees, etc. must be included. - ''Possibility of incurring losses'' and ''possibility that the loss may exceed the value of deposit received from customers'' must be stated, if any.
Obligation to issue documents at a time of contract (Article 37-4)	- The terms and conditions, etc. of the contract for financial instruments transactions must be stated.
Various prohibited conducts (Article 38)	- Solicitation by making false statements or by providing decisive judgments on uncertain matters is prohibited.
	- Solicitation of customers who have not requested such solicitation by making visits or phone calls is prohibited (a ban on unwanted solicitation).
	- Solicitation without confirming the customer's intention to accept solicitation in advance (Obligation to confirm customer's acceptance of solicitation).
	- Continued solicitation of customers who have once indicated that they do not wish to enter into a contract is prohibited (a ban on re-solicitation).
Prohibition of compensation of losses (Article 39)	- Guarantee against losses, guarantee of yields, subscription of loss compensation and execution of loss compensation are prohibited.
Requirement for suitability (Item 1, Article 40)	- Efforts must be made to avoid business situations in which inappropriate solicitation could result in lack of investor protection in light of the customer's knowledge, experience, asset position and purpose of signing a contract.

b) Rules of Conduct relating to ''Investment Advisory'', ''Investment Management'' and ''Customer Asset Administration''

- Financial Instruments firms should comply with, for example, the duty of loyalty and fiduciary duty (Articles 41 and 42), etc. in conducting ''investment advisory'' or ''investment management''.
- Financial instruments firms should comply with fiduciary duty and the obligation of segregation of assets (Article 43 through Article 43-3) in conducting ''customer asset administration''.

6) Flexible Regulation according to Customer Categories
Rules of conduct based on the existing SEL, etc. are applied across the board regardless of the categories of investors. In contrast, the FIEL has established the following systems to facilitate the supply of risk capital while assuring customer protection.
a) Classification of Professional Investors and General Investors

- Investors corresponding with qualified institutional investors, the Japanese government, the Bank of Japan, and corporations to be designated by cabinet office ordinances are regarded as professional investors (paragraph 31, Article 2 of FIEL).
- Among them, corporations to be designated by cabinet office ordinances (public companies are presumed) are eligible to be treated as general investors (Article 34-2).
- Corporations corresponding with general investors are eligible to be treated as professional investors (Article 34-3).
- All individuals are basically regarded as general investors. However, individuals who meet certain criteria to be designated by cabinet office ordinance may be treated as professional investors (Article 34-4).

b) Exceptions for Professional Investors
Sales and solicitation to professional investors are exempt from rules of conduct set for correction of the information disparity will be exempt (Article 45. On the other hand, the dealer will not be exempt from the rules of conduct set for market integrity such as the prohibition of compensation of losses, etc.).

(Reference) Reporters of special business activities
Under the FIEL, financial instruments firms are required to register for self-offering for interests in collective investment schemes and self-management of properties of collective investment schemes (refer to 2) and 3) ). However, in order to promote financial innovation through the sound development of funds dealing with professional investors, registration is not required.
Instead, notification in the form of ''Reporters of special business activities'' is required for firms dealing with such funds (concretely funds dealing only with qualified institutional investors as well as general investors with less number of investors than the number to be designated by government ordinances). Limited rules of conduct such as the prohibition of compensation of losses, etc. (Article 63) will be applied.

7) Treatment of Deposits, Insurances, etc. with Strong Investment Characteristics
The latest legislation aims to build a cross-sectoral legal system for customer protection through the revision of other financial laws in addition to the FIEL, based on the view that the same customer protection rules should be applied to financial instruments with the same economic functions.

a)	Deposits, Insurances, Trusts, etc. - Among financial instruments, deposits are regulated by the Banking Law, insurance by the Insurance Business Law and trusts by the Trust Business Law. Therefore, they are not directly subject to regulation by FIEL, but the respective financial laws have been amended to apply the same rules of conduct as those under FIEL to ''sales and solicitation'' of deposits, insurances, trusts, etc. with strong investment characteristics. - For example, the Banking Law applies the same rules of conduct in the FIEL mutatis mutandis to ''sales and solicitation'' for ''contracts on specific deposits, etc.'' (deposits, etc. with the risk of diminishing the principal due to fluctuations in the interest rate, exchange rate, etc. to be designated by cabinet office ordinances) concluded by banks, etc. (Article 13-4 of the revised Banking Law).
b)	Real Estate Syndications - Real estate syndications are excluded from the scope of regulations under the FIEL as they will continue to be regulated by the Real Estate Syndication Business Law, which stipulates many regulations unique to real estate (paragraph 2-5-c of Article 2 of the FIEL). On the other hand, the Real Estate Syndication Business Law has been amended to apply the same rules of conduct as those under FIEL.
c)	Commodities Futures Transactions - The FIEL explicitly states that commodities futures trades will continue to be regulated by the Commodity Exchange Law and will not be subject to the FIEL due to their aspects as a commodities market system (paragraphs 24-4 and 25-3 of Article 2 of the FIEL). On the other hand, the Commodity Exchange Law has been amended to apply the same rule of conduct as those under the FIEL.

8) Development of Other Systems for Customer Protection

a) Financial Instruments Sales Law
The Law on Sales of Financial Products (''Financial Products Sales Law'') established in 2000 sets forth special provisions on damages under the Civil Code relating to the sale of a wide range of financial instruments, including deposits, insurances and securities. The Financial Products Sales Law provides for matters to be explained by dealers to customers when selling financial instruments, and stipulates that dealers are liable for damages if they fail to provide necessary explanation upon the sale of a financial instrument, the firm will bear liability for damages, whether at fault or not, with any losses incurred on the principal being presumed to be losses to be compensated .

The latest legislation amended the Financial Products Sales Law to enhance user-protection. For example, the scope of duty to provide explanations of financial instruments firms have been enhanced (Article 3 of the revised Financial Products Sales Law), including:

- ''Possibility of incurring losses beyond the original principal'' was added to the matters to be explained, in addition to ''possibility of loss to principal'' which is designated in the SEL;
- ''Important part of schemes of financial instruments'' was added to the matters to be explained;
- The criteria for determining whether or not a financial instruments firm has fulfilled its duty to provide an explanation must be based on the method and depth of explanation required to suit the customer's knowledge, experience, asset position and purpose of signing the contract, by incorporating the requirement for suitability.

b) Other (Recognized Investor Protection Association System, etc.)
In addition to the above, the FIEL has developed various systems for investor protection, including developing a system of ''recognized investor protection associations'' (Article 79-7 onwards) as a framework for the government to recognize private organizations that resolve complaints and mediate disputes relating to financial instruments businesses other than so-called self-regulatory organizations (SROs) and enhance the reliability of such businesses.

The next edition (Part 3) will review other provisions amended under the FIEL.