Japan Takes First Step Into J-SOX World

Corporate Japan and its investors are bracing for a brave new world this week: The nation’s landmark Financial Instruments and Exchange Law—a precursor to Japan’s own Sarbanes-Oxley reforms—finally goes into effect.

Dubbed informally in Japan as kinshohou (an abbreviation of the law in Japanese), it is a fundamental reform of investment law that touches on all securities outside the banking and insurance sectors. Japanese officials are quick to distinguish between kinshohou and J-SOX in the strictest meaning: J-SOX refers specifically to the internal control provisions of the law, which won’t take effect until next April 1. Kinshohou encompasses the rest, and becomes active on Sept. 30.

Tokyo University law professor Hideki Kanda, a leading expert on kinshohou, says it was driven by too many companies and private investment funds selling securities to consumers without properly explaining the risks the products entails. A case in point is the now-bankrupt Heisei Denden, an Internet services provider whose executives were arrested and charged with fraud.

Kanda

“In the last few years, there’s been damage done to retail investors with risky financial products,” Kanda says. “There were laws to regulate financial products by the banking and insurance sector, but the rest was ungoverned. There was no law to regulate vendors carrying such risky products.”

The law details how companies must present the risks and fees involved in their financial products, down to how prospectuses and similar pamphlets should look. For example, the text explaining potential risks cannot be smaller than the rest of the text in the pamphlet. Rules will be relaxed when professional investors are involved.

“This is the Big Bang after the first Big Bang,” says Kanda, referring to Japan’s last wave of financial reforms in the 1990s; that Big Bang ended in 2001. Of all the reforms in this next wave, Kanda says, “kinshohou is the main feature.”

Kanda says the internal control regulations of J-SOX were added due to the recent corporate fraud scandals that rocked Japan in the mid-2000s, just as Enron and WorldCom shook the United States at the start of the decade. Japan has been taking its cues from financial rules in the United Kingdom, he says, and he describes the Financial Instruments and Exchange Law as equivalent to the 1986 version of the Financial Services Act there.

Kanda says he is aware kinshohou is prompting some investment funds to leave Japan for elsewhere in Asia. In the new law, all funds that are active in Japan must register their business with the government, a provision added to prevent the recurrence of frauds like those committed at Heisei Denden.

“Some funds have decided to take their businesses elsewhere to countries like Singapore, rather than register their businesses here,” Kanda says. “It remains to be seen what the funds will decide to do. Hopefully they will just go ahead and register their businesses after Sept. 30th.”

Watanabe

Financial Services Minister Yoshimi Watanabe, speaking to foreign reporters earlier this month, said the new law is the second part of a three-phase plan to reform Japan’s financial markets; the third phase is another, undetermined bundle of regulation that will come sometime in the future. “We have the three phases ‘hop, step and jump’ and we’re at the ‘hop’ stage,” Watanabe said. “We hope Japan’s financial market will be attractive to investors worldwide and money from around the world will flow to Japan. We hope Japan’s 1500 trillion yen in private financial assets will go from savings to more investment.”

Driving Toward Securities Investment

Behind the law is a need to push the Japanese public away from pouring their money into savings accounts—they keep roughly half of their 1,500 trillion yen in the bank—and toward investment in stocks and other securities, like U.S. investors do. Such savings-loving behavior by the Japanese public can cause economic problems, as happened in the 1990s when Japanese banks went through a prolonged period of carrying bad loans on their books.

The Financial Instruments and Exchange Law, Watanabe said, was revised “to be more comprehensive and cross-sectional to ensure to protect investors and for the market to be more transparent.”

Watanabe further likened Japan’s financial market to a fish pond. “We want Japan’s financial market to be a pond where fish from all over the world would be attracted to,” he said. “We need an ecosystem where there’s lots of plankton, lots of food. I don’t mean to make a market that is made of distilled water. If a piranha gets mixed into the pond, we do intend to pick them out.” (Watanabe then clarified that he does not view hedge funds as piranhas.)

Toshitaka Hagiwara, a special adviser to construction equipment maker Komatsu, calls the law part of a fundamental shift Japanese society is making toward being more aggressive about punishing corporate crime once it has occurred. He says regulators should work to update businesses on upcoming changes and hold forums to talk to business leaders, so they will understand and cooperate with the new law rather than overreact.

“There’s a risk that interpretation to the new laws can be stretched,” Hagiwara says. “If corporations become afraid to take risks, it could lead to a shrinkage of economic activity.”

Japan’s Attorney General Tadaki Keiichi, recently speaking at a public forum on the law, expressed a similar sentiment.

Keiichi

“Japan is at a time where an enormous number of ordinary people participate in various economic activities,” he said. “It’s crucial that the mass can participate in the [money] market feeling secure. Rules need to be followed. Violators need to be prosecuted. This will be even more so going forward.”

Financial Services Agency Commissioner Takafumi Sato—Japan’s counterpart to Christopher Cox, Chairman of the U.S. Securities and Exchange Commission—also spoke at the forum.

“We want Japanese companies to compete on executing best business practices,” Sato said. “I think the agency’s role is to show businesses the direction on where to be competing on. We want businesses to not merely follow the rules but to live up to the principles we outline.”

Sato said he encourages financial institutions to communicate with regulating authorities on a regular basis, asking what goals regulators have and what they regard as potential problems.

“If they are in the know, they will be aware of the principles that are motivating us,” Sato said. “For companies, this will be a benefit because as changes come up, they can forecast them. The cost to adapt to new regulations, as a result, will go down.”