| 1. |
Foreword |
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The First Subcommittee of the Sectional Committee on Financial System of the Financial System Council headed by Hideki Kanda (Professor of Graduate Schools for Law and Politics, University of Tokyo) compiled a report titled
 ''Legislation for the Investment Services Law (provisional title)'' on December 22, 2005.
The First Subcommittee compiled the Interim Report describing the basic concept, etc. of the Investment Services Law (provisional name, hereinafter referred to as
''Investment Services Law'') on July 7, 2005. The Subcommittee invited opinions widely on the Interim Report in September 2005, and in response, more than 100 opinions were submitted, including those from financial groups, bar associations, etc. The First Subcommittee resumed deliberations on October 5, 2005 and studied the major points under discussion and other such matters towards the enactment of the Investment Services Law based on the Interim Report, while drawing upon these opinions. The latest report was compiled as a result of lively discussions that took place at nine public meetings convened over a three-month period.
This paper provides a summary of the report, excluding matters relating to the Take Over Bid (TOB) system and the large shareholding report system, which are explained in a separate paper.
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| 2.
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Background, Purport and Objective of Investment Services Law |
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(1) |
Background to Investment Services Law
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As financial instruments outside the existing scope of user protection have been found to be sold fraudulently in some cases, the First Subcommittee has been recommending the enhancement of measures to protect users individually from such financial instruments. Legislative action has been taken based on these recommendations, as exemplified by the application of the revised Securities and Exchange Law to collective investment schemes following the revision of the said Law (enforced in December 2004) and the introduction of restrictions on foreign exchange margin trading pursuant to the amendment of the Financial Futures Trading Law (enforced in July 2005).
However, there are ''loopholes'' in the existing legal framework for user protection, as evident in the recent reports on losses incurred by many general investors due to funds conducting businesses which use Tokumei-Kumiai (TK) as its vehicle and cases involving improper interest rate swaps with clients of some financial institutions. It is absolutely imperative to develop a comprehensive and cross-sectional framework to protect users from a wide range of financial instruments. From this standpoint, the First Subcommittee's report recommended the enactment of the Investment Services Law.
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(2) |
Purport and Objective of Investment Services Law |
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The first purport and objective of the Investment Services Law is to thoroughly implement user protection rules and enhance user convenience.
''Loopholes'' outside the scope of the existing legal framework for user protection will be closed, the existing vertically-divided business law will be revised, and the same rules will be applied to financial instruments with the same economic functions. On the other hand, user protection requirements will be fulfilled and user convenience will be improved while promoting financial innovation by establishing a flexible regulatory structure, including relaxing the regulations prescribed with general investors in mind when they are applied to cases in which the customer is a professional investor. The second purport and objective is to ensure market functions to shift funds
''from savings to investment'', and the third is to adapt to the globalization of financial and capital markets.
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| 3.
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Coverage of Investment Services Law |
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(1) |
Basic Concept |
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The Interim Report states that financial instruments to be covered by the Investment Services Law (hereinafter referred to as
''investment instruments'') should include as wide a range of financial instruments as possible which fulfill the following criteria:
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| (i) |
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Contribution of money and possible return of money, etc.; |
| (ii) |
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Relates to assets, indexes, etc.; |
| (iii) |
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Takes risks with an expectation of higher returns (economic utility). |
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"Risk" in (iii) above is regarded as either "market risk" or "credit risk," whereas "return" is defined primarily in the context of expectations for
''monetary profits''.
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(2) |
Treatment of Deposits, Insurances, etc. |
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As for the treatment of deposits based on the above definition, it is deemed appropriate at this point to apply the Investment Services Law to foreign currency deposits which have the risk of falling in value below the yen-denominated principal due to exchange rate fluctuations, as well as yen-capital-guaranteed, yen-denominated derivative deposits that can materially cause a reduction in the principal due to early-withdrawal penalties, on the grounds of being products with strong investment characteristics. As for the treatment of insurances, it is deemed appropriate at this point to apply the Investment Services Law to variable insurance, annuities and foreign-currency-denominated insurance, on the grounds of being products with strong investment characteristics.
Syndicate loans and asset-backed loans (ABL) will not be regulated following the latest legal revision, due to the fact that most loan providers are financial institutions who make a business out of lending. However, further studies should be conducted, while keeping an eye on the spread of participants, etc.
It is deemed appropriate to include derivative transactions into the scope of application of the Investment Services Law, including interest rate and currency swaps, credit derivatives and weather derivatives.
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(3) |
Prospects for Financial Services and Markets Act |
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As for the prospects for a British-type Financial Services and Markets Act, the First Subcommittee's report considers that recent problems and cases are difficult to deal with under the current laws, and as a matter of urgency, it would be appropriate to firstly work on promptly enacting such a law with respect to
''financial instruments with investment characteristics'' to which the application of comprehensive and cross-sectional regulations have generally been agreed upon. The First Subcommittee will continue to vigorously study a more comprehensive regulatory framework targeted at financial instruments in general, in consideration of the progress in the enactment and implementation of the Investment Services Law, the characteristics of various types of financial instruments, the medium and long-term modality of the financial system, etc.
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| 4.
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Regulation on "Investment Services Business
(provisional name)" |
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(1) |
Scope of Investment Services Business |
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It is deemed appropriate that "sales and solicitation," "asset management and providing advice" and "administration of assets" are within the scope of "investment services business (provisional name)". The scope of the core business is greater than existing securities businesses, whose core business is regarded as sales and solicitation.
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(2) |
Treatment of Banking Business, Insurance Business, Trust
Business, etc. |
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It is deemed appropriate to exclude banking businesses, insurance businesses, trust businesses, etc., from the scope of registration of investment services business, considering that they are subject to sophisticated business regulations based on licensing systems, etc., under the Banking Law and the like, and even products without investment characteristics (settlement deposits, etc.) are regulated, not to mention that conflict of interest (the basis of Article 65 of the Securities and Exchange Law) and the possibility of banks abusing their dominant positions are still crucial points of discussion. The existing framework of Article 65 of the Securities and Exchange Law will be maintained, including the registered financial institutions system.
It is also deemed appropriate to regard bank agencies, non-life insurance agents, life insurance agents and trust bank agencies as banking businesses, etc., and therefore exclude them from the scope of registration of investment services business.
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(3) |
Flexible Regulatory Structure of Investment Services Business |
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It is deemed appropriate to build a flexible regulatory structure by creating the following three categories according to the scope of the business while assuming cross-sectional coverage of investment services businesses: |
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| (i) |
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"First business (provisional name)", which involves all operations associated with all investment instruments; |
| (ii) |
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"Second business (provisional name)", which involves asset management relating to investment instruments such as sale of illiquid investment instruments and providing investment advice on investment instruments; and |
| (iii) |
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''Brokerage business (provisional name)'', which involves brokering deals entrusted by other investment service companies (affiliate system). |
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Entry into investment services business will be deregulated, as it is
deemed appropriate to shift to a registration system, including investment
trust management business, discretionary investment management business,
etc., which are currently based on a licensing system.
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| 5. |
Codes of Conduct of Investment Services Business |
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(1) |
Basic Framework |
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As for the basic framework of the Investment Services Law, it is deemed appropriate to apply the codes of conduct to financial instruments with the same economic functions, regardless of the type of business, assuming that they have the general characteristics relating to the sale of financial instruments, etc. Accordingly, it is deemed appropriate to apply the codes of conduct under the Investment Services Law, even to businesses outside the scope of the registration system for investment services business such as banking businesses if they sell or solicit for deposits, insurance, etc. with strong investment characteristics.
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(2) |
Main Codes of Conduct |
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It is deemed appropriate to regard the compatibility principle under the Investment Services Law as a code similar to the existing Securities and Exchange Law (Article 43-1), not only the development of structures (Article 12-2-2 of the Banking Law, Article 13-7 of the Enforcement Regulations of the Banking Law, etc.).
It is deemed appropriate to place the duty to provide an explanation as a code of conduct under the Investment Services Law, similar in content to the one under the Financial Instruments Sales Law (a civil obligation). This will make it possible to take supervisory action directly in the event that a business breaches the duty to provide an explanation. It is deemed appropriate to review the content of the Financial Instruments Sales Law and conduct studies with the aim of enhancing the provisions, including adding a "transaction framework" with respect to the duty to provide an explanation.
For the prohibition of unsolicited calls, it is deemed appropriate to establish, for the purpose of user protection, a general framework that can dynamically deal with cases in which conformity with the compatibility principle can hardly be expected, while assuming the same scope of application as the existing one (financial futures transactions). Further, it is deemed appropriate to prohibit repeated calls through the introduction of new regulations, including looking into the possibility of applying such regulations to financial futures transactions at stock exchanges.
For the disclosure of commissions, it is deemed appropriate to make it obligatory to disclose commissions paid directly or indirectly by the customer to a business (trust fees and sales commissions for investment trusts, management expenses of variable annuities, etc.).
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| 6. |
Other |
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(1) |
Distinction between Professional Investors and General Investors |
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For the purpose of building a flexible regulatory structure to both protect users in an appropriate manner and facilitate the supply of risk capital, investors are divided into professional investors (such as institutional investors) and general investors in an effort to build a flexible regulatory structure. There are four categories of investors: (i) a professional investor who does not have the option to be reclassified as a general investor; (ii) a professional investor who has the option to be reclassified as a general investor; (iii) a general investor who has the option to be reclassified as a professional investor; and (iv) a general investor who does not have the option to be reclassified as a professional investor.
As for the codes of conduct that are inapplicable to professional investors, it is deemed appropriate to make the codes of conduct aimed at rectifying the information gap (such as the duty to issue documents to clients) inapplicable, while making those aimed at ensuring fairness in the market (such as prohibition of misrepresentation, prohibition of compensation for losses, etc.) applicable.
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(2) |
Collective Investment Schemes (Funds) |
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Considering the reports on losses incurred by many general investors due to funds conducting businesses which use Tokumei-Kumiai (TK) as its vehicle, it is deemed necessary to establish effective, comprehensive, cross-sectional regulations with respect to funds. The Interim Report stated the need to apply to funds: (i) disclosure requirements; (ii) business regulations and codes of conduct relating to sales and solicitation; and (iii) minimal regulatory framework for administration of assets, fund manager's fiduciary responsibilities, investment report, etc. On the other hand, the First Subcommittee's report states that it would be appropriate to focus on looking into business regulations that enable the administration to take the quickest and most direct action against violators with respect to funds targeted at general investors (sales and solicitation including private offering and asset management).
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(3) |
Civil Liability Clause (Review of Financial Instruments Sales
Law) |
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It is deemed appropriate to examine the Financial Instruments Sales Law with the aim of making it easier to use for customers, in light of judicial precedents which recognized civil liability in tort with respect to financial instruments.
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(4) |
Disclosure Requirements |
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As for disclosure requirements, its is deemed appropriate to divide investment instruments into corporate-finance-type instruments and asset-finance-type instruments according to their characteristics, and develop disclosure requirements with respect to each classification.
Furthermore, it is deemed appropriate to introduce a quarterly reporting system and further develop the internal control system for financial reporting with respect to listed companies before doing so for other disclosing companies depending on the liquidity of investment instruments, while improving the disclosure system of some investment instruments with limited liquidity due to transfer restrictions (such as instruments whose holders are within a certain scope and are identifiable) by directly providing the disclosure documents instead of public disclosure.
As for the scope of qualified institutional investors, it is deemed appropriate to expand the scope of qualified institutional investors with respect to business corporations, look into paving the way for certain non-business corporations and individuals to become qualified institutional investors, and substantially relax or abolish the restrictions on the number of qualified institutional investors subject to solicitation (capped at 250) for small-scale private placement.
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(5) |
Organization of Stock Exchanges with Self-regulatory Functions |
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A stock exchange that is incorporated in the form of a stock corporation is required to have its self-regulatory functions executed independently of other operations, due to the risk of conflict of interest arising between its commercial nature as a stock corporation and the stock exchange's operations with public characteristics. As the environment surrounding the stock exchange and the market operator's policies for designing its market vary from exchange to exchange, the market operator should be able to choose the organizational structure at its own discretion, in consideration of quality control of the trading floor.
In the event of the listing of a stock exchange that is incorporated in the form of a stock corporation, it is deemed appropriate to demand the stock exchange to ensure the organizational independence of its self-regulatory functions, and to inspect the existing system (including regulations on major shareholders) and take appropriate measures if necessary, considering the recent revision of company laws.
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(6) |
Self-Regulatory Organizations (SROs) |
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While the functions of self-regulatory organizations (SROs) vary under the existing business laws, it is deemed appropriate under the Investment Services Law to give each SRO the same functions as the Japan Securities Dealers Association (JSDA), which has the strongest characteristics as an SRO.
To ensure regulatory effectiveness without imposing legal obligations to become a member of an SRO, it is advised that a framework be developed to make non-members establish in-house rules which take SRO rules, etc., into account.
In addition, it is deemed appropriate to develop a framework to accredit operations relating to the resolution of complaints and mediation of disputes involving private organizations other than SROs under the Investment Services Law in order to ensure the reliability of such operations, and promote the resolution of complaints and mediation of disputes through such voluntary efforts.
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| 7. |
Afterword |
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It is a matter of urgency that the Investment Services Law--a comprehensive and cross-sectional law on financial and investment services--be enacted promptly, for the purpose of further promoting structural reform in financial and capital markets and creating a dynamic financial system. To this end, work is currently being done to submit relevant bills at the ordinary session of the Diet this year (Bill for Partial Revision of Securities and Exchange Law, etc. and Bill for Establishment, etc, of Related Laws associated with Enforcement of Law for Partial Revision of Securities and Exchange Law, etc. (provisional name)).
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For further information, please access FSA's official website > "Councils" > "Financial System Council" > The 1st Subcommittee's Report 2005
"Dec.22" and
"Ref." |
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In response to the rapid increase and the diversification of mergers and acquisitions (M&A) in recent years, the Financial Services Agency (FSA) established the Working Group on Takeover Bid (TOB) System, etc. under the First Subcommittee of the Financial System Council in July 2005, with the mission to deliberate on the modalities of the TOB system and other matters. The Working Group convened eleven times and engaged in vigorous deliberations, and reported the results of studies to the First Subcommittee of the Financial System Council on December 22. The key areas which require review in the existing system according to the report are outlined below.
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Recommendations on Scope of Application of TOB Regulations |
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Under the existing system, there is an obligation to resort to TOB if the shareholding ratio after the purchase of shares will exceed one-third of all outstanding shares, even if the purchase involves an extremely small number of buyers. This is the so-called "1/3 rule". Suppose that someone buys up to 32% of all outstanding shares outside the market and subsequently purchases 2% all outstanding shares within the market; by performing such a trade, it is possible to acquire more than a third of all outstanding shares, etc., without resorting to TOB. It would be appropriate to take necessary measures so that TOB regulations would clearly be applicable to cases in which, for example, the total shareholding ratio resulting from off-exchange transactions performed within a certain period and transactions within the stock exchange, etc., exceeds one-third of all outstanding shares.
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| 2. |
Recommendations on Ensuring Transparency in TOB Regulations and Modality of TOB Period, etc. |
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Disclosure by the bidder in TOB procedures plays an important role for shareholders and investors to make a proper investment decision. It would be appropriate to further enhance disclosure by the bidder in TOB notices, etc.
The targeted company's opinion on the TOB is also an important piece of information for shareholders and investors to make a proper investment decision. Therefore, it would be appropriate to oblige the targeted company to announce its opinions.
Furthermore, it would be appropriate to provide a certain institutional framework to give the targeted company the opportunity to ask the bidder questions in its statement of opinions if the targeted company has any questions for the bidder when announcing its opinions.
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| 3. |
Recommendations on the TOB Period |
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Under the current system, the TOB period is between 20 and 60 days, depending on the choice of the bidder. In order to ensure that shareholders and investors are given sufficient time to carefully consider the TOB, it would be appropriate to redefine the TOB period in terms of business days, taking into consideration TOB launched at a time when there are consecutive holidays, etc.
In addition, it would be appropriate to approve the extension of the TOB period by the targeted company by up to 30 business days, if, for example, the target company makes a counteroffer and shareholders need to be given sufficient time to carefully consider the counteroffer.
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| 4. |
Recommendations on So-called Anti-takeover Measures and
Modality of TOB Regulations |
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Under the existing system, TOB can be withdrawn only if the targeted company goes bankrupt or merges with another company or in other limited cases. However, it is permissible to withdraw the TOB, if so-called anti-takeover measures are serious obstacles to achieving the objectives of the TOB--for example, in cases where the targeted company, or its subsidiary, decides to issue new shares or stock purchase warrants or decides to sell its material assets, or if the so-called anti-takeover measures would definitely not be cancelled.
Under the existing system, it is not permissible to change the terms and conditions of TOB to the disadvantage of subscribing shareholders, such as reducing the TOB price. However, it would be appropriate to allow the reduction of the TOB price if the share price is diluted as a result of a share-split, etc., executed by the target company, provided that the reduction is proportionate to the dilution.
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| 5. |
Recommendations on Ensuring Fairness between Investors and
Shareholder Protection in TOB |
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Under the existing system, if the total number of subscribed shares, etc., exceeds the number of purchases planned, the bidder is allowed to not purchase all or some of the oversubscribed portion based on the percentage method.
However, TOB that leads to delisting, etc. might put small shareholders in an extremely vulnerable position as a result of having leftover shares. Therefore, it would be appropriate to oblige the bidder to buy all shares if, for example, the shareholding ratio exceeds two-thirds of all outstanding shares after the TOB.
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| 6. |
Recommendations on Investor Protection in Event of Competition
over TOB |
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If there is competition over the purchase of shares, etc. that have an impact on corporate control (for example, while one party is engaged in TOB, another party buys huge volumes of the shares, etc., on the stock exchange) it is conceivable to make TOB mandatory. However, it would be appropriate to look into making TOB mandatory under fairly strict conditions, so that it is not overregulated. In addition to the above, the Working Group recommends that it would be appropriate to conduct necessary review on the modality of the large shareholding report system, while giving due consideration to the impact, etc., on the securities market, in order to enhance transparency and fairness in securities transactions.
Specifically, as for the reporting deadline, frequency, etc. under the special reporting system which allows less frequent reporting in order to prevent institutional investors from being burdened by excessive workloads, it would be appropriate to bring forward the reporting deadline as much as possible, to have the shareholding status as at the base date reported, for example, within five days rather than two weeks. In regards to this matter, it has been pointed out that reporting should not have a shorter deadline or be less frequent under the special reporting system. If the reporting deadline is to be shortened or the reporting frequency is to be reduced, further studies should be conducted as to whether or not there is any room for regulatory improvements, etc., so as to ensure that even institutional investors would properly submit general reports according to the purpose of shareholding. Moreover, upon determining whether or not the submission of large shareholding reports should become mandatory, it would be appropriate to make streamlining efforts such as allowing joint shareholders to calculate the shareholding ratio by netting the figures that have been redundantly declared by both parties.
At present, if a party performs a transaction that results in a shareholding ratio of more than 10%, the said party is required to submit a general report even if it is subject to the special reporting system. It is necessary to conduct a review so that a general report will be submitted when the performed transaction leads to a reduction in the shareholding ratio from more than 10% to below 10%.
These recommendations include many legal matters. The FSA plans to vigorously work on the recommendations, in conjunction with dealing with the "Bill for Investment Services (provisional title)" which is scheduled to be submitted at the ordinary session of the Diet.
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Recent incidents of improper disclosure are claimed to have been caused partly by the failure of internal controls for ensuring the reliability of disclosure to function effectively. In the United States, the Sarbanes-Oxley Act has enforced mandatory evaluation by the management and mandatory audits by Certified Public Accountants (CPAs) with respect to internal controls for financial reports since 2004. In response to such a trend, the Subcommittee on Internal Controls of the Business Accounting Council headed by Shinji Hata (Professor at Graduate School of Aoyama Gakuin University) has deliberated on the standards for evaluation by the management and audits by CPAs, etc. with respect to the effectiveness of internal controls for financial reports, and compiled its report titled "Evaluation and Auditing Standards for Internal Control Reported in Financial Reports" on December 8, 2005.
The draft standards presented in the report consist of three parts: (1) "I. Basic Framework of Internal Control" that describes the definition and the conceptual framework of internal control itself, which the management has the role and responsibility to develop and operate; (2) "Evaluation and Reporting of Internal Control for Financial Reports", which shows the approach to evaluation by the management with respect to the effectiveness of internal controls for financial reports; and (3) "III. Auditing of Internal Controls for Financial Reports", which explains the approach to the standards of audits conducted by CPAs, etc.
| 1. |
Basic Framework of Internal Control |
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Internal control is basically a process that is carried out by all members of the company, in order to fulfill four corporate objectives: (1) effectiveness and efficiency of operations; (2) reliability of financial reports; (3) compliance with laws and regulations relating to business activities; and (4) preservation of assets. It is comprised of six basic elements: (1) control environment; (2) response to risks and evaluation; (3) control activities; (4) information and communication; (5) monitoring and; (6) IT support. Among them, internal controls aimed at ensuring the reliability of financial reports are defined as "internal controls for financial reports", and are subject to the evaluation and audit based on the draft standards.
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| 2. |
Evaluation and Report of Internal Control for Financial
Reports |
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The management assumes the role and the responsibility to develop and operate internal controls, and is required to directly evaluate the effectiveness of internal controls for financial reports and report the results in the form of an internal control report to the public. Upon evaluating the effectiveness of internal controls, the management must first evaluate internal controls that have a material impact on the financial reports as a whole (company-wide internal control), and evaluate the internal controls relating to operations based on the results.
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| 3. |
Audit of Internal Controls for Financial Reports |
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The auditor in charge of auditing the financial statements of the
company audits the evaluation of the effectiveness of internal controls
for financial reports performed by the management, to determine the
appropriateness of the evaluation results. The auditor compiles the audit
results in the form of an internal control audit report, and submits it to
the management.
The report by the Subcommittee on Internal Controls describes the modality of internationally accountable and effective standards that are consistent with the company laws of Japan, verifies the implementation status, etc., in the United States where the system was introduced before Japan, and incorporates measures to prevent costs, etc., from becoming excessive, in consideration of debates over whether or not mandatory evaluation by the management and mandatory audits by auditors with respect to internal controls for financial reports would be an excessive burden.
Furthermore, for the draft standards presented in the said report, there have been many requests for the development of detailed practical guidelines (implementation standards) that would be applicable at the working level. Accordingly, the Subcommittee decided to conduct further studies on implementation standards, and established a working group headed by Nao Hashimoto (professor at Graduate School of Aoyama Gakuin University) under the Subcommittee in December 2005.
The report submitted by the First Subcommittee of the Financial System Council on December 22, 2005 recommends that evaluation by the management and audits by CPAs be made mandatory based on the report by the Subcommittee on Internal Controls, in order to ensure the appropriateness of financial reports of listed companies. It also recommends the introduction of a system that obliges the management to confirm the appropriateness of statements in securities reports at the same time.
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