Mis-Selling Cases

When a client's derivatives sale produces a loss, the way it was sold may be questioned. Sales and compliance staff can draw on what past judgments and reports questioned when they review how they explain products and check suitability.

How the three cases differ

The three cases below all question how derivatives were sold to clients, but what was questioned differs.

A case of soliciting option selling

The Supreme Court judgment of July 14, 2005 decided whether a securities company's recommendation that a client sell Nikkei 225 options was a tort that violated the suitability principle (an unlawful act that can ground a claim for damages)¹. It held that the solicitation in this case did not deviate markedly from the suitability principle².

The client was a seafood wholesaler in Hiroshima. In September 1984 it deposited 500 million yen of investment funds with a securities company and left securities trading to it. The trading went on for about 10 years, and total trading volume reached about 180 billion yen. When Nikkei 225 option trading began on the Osaka Securities Exchange in June 1989, the client began trading these options as well. The large losses came in the third and fourth rounds of option trading, which involved many selling transactions. The total loss was about 20.9 million yen in the third round and about 207.21 million yen in the fourth³.

Buying an option cannot lose more than the premium paid. Selling an option limits the profit to the premium, while the loss can be unlimited or close to it. The judgment explained this difference and described selling transactions as an extremely high-risk type among securities transactions, for which the degree of suitability required is also fairly high⁴.

The lower court (the High Court that ruled on the case before the Supreme Court) upheld part of the client's claim. It held that recommending selling to a client who lacked the knowledge, experience, and ability to limit or avoid the risk of selling violates the suitability principle unless there are special circumstances. The Supreme Court did not accept this and set out the following standard. A solicitation is also unlawful under tort law when a securities company's representative actively recommends a transaction that does not match the client's intentions and circumstances and carries a clearly excessive danger. The same applies to any other solicitation that deviates markedly from the suitability principle and has the client trade⁵.

That judgment does not look only at the general risk of the selling type of transaction. It weighs the specific characteristics of the product, such as what the underlying asset of the option is and whether it is exchange-traded, together with the client's investment experience, familiarity with securities transactions, wishes, and assets⁵.

In this case the Court took into account that Nikkei 225 options are exchange-traded products that have passed a review of their product features. It also considered the following circumstances on the client's side⁶.

• The client had funds of more than 2 billion yen, although they had to be repaid.
• The managing director had experience in spot transactions, margin transactions, futures transactions, and others, on a scale of hundreds of billions of yen every year.
• The client set its own policy of stopping if option losses exceeded 10 million yen, and it did stop.

The Supreme Court held that the lower court's judgment violated the law. It set aside the part of that judgment against the securities company and then remanded the case to the Tokyo High Court to examine other grounds of liability, such as breach of the duty to explain². One justice wrote a supplementary opinion, a separate opinion added to the majority opinion. It said that the court on remand needs to consider whether a securities company has a duty to give guidance or advice urging improvement when a client's trading is extremely skewed toward selling and the client may become unable to manage the risk⁷.

A case on explaining an interest rate swap

The Supreme Court judgment of March 7, 2013 decided the duty to explain when a bank proposed an interest rate swap to a company, and held that in this case there was no breach of that duty⁸.

The client was a stock company that ran pachinko parlors and other businesses. On December 30, 2003, it borrowed 150 million yen from a bank at a floating rate equal to the short-term prime rate plus 0.75% per year. A bank employee understood that many of the client's bank loans carried floating rates, and proposed an interest rate swap as a product that limits the risk when interest rates rise⁹. The terms of the contract concluded on March 4, 2004 were as follows¹⁰.

Under this swap, on a notional amount of 300 million yen, the client calculates an amount at a fixed rate of 2.445% per year and the bank calculates an amount at a floating rate of 3-month TIBOR plus 0%. Every 3 months, only the difference between the two amounts is paid. The client pays when the floating rate is below the fixed rate and receives when it is above.

From June 8, 2005 to June 7, 2006, the client paid the bank a total of 8,830,355 yen, settling the difference between the fixed and floating rates set in the contract¹¹. This amount is larger than the maximum annual amount that can be calculated from the contract terms when the floating rate is 0% or higher. That maximum is 7.335 million yen (notional amount of 300 million yen × fixed rate of 2.445%).

Whether this contract is a loss or a gain for the client depends on the level of the floating rate. Consider a hypothetical example in which the client, under the contract terms of the judgment, borrows 300 million yen, the same as the notional amount, at 3-month TIBOR plus 1%. The table compares amounts per year for the first year after the trade starts, if TIBOR stays constant. In the table, 0.09% is the actual value that the proposal showed as the 3-month TIBOR on January 15, 2004¹². The 4% and the 1% loan spread are assumed levels for this example.

At both levels, the cost combined with the loan is fixed at 3.445% per year (10.335 million yen). If the floating rate stays low, the cost is higher than without the swap (at 0.09%, the loan interest alone would be 3.27 million yen). If the floating rate rises, the cost is lower than without the swap (at 4%, the loan interest of 15 million yen becomes 10.335 million yen).

The lower court found that the bank had not explained the following three points, held that the explanation was extremely insufficient and that the bank had breached its duty to explain, and declared the contract invalid.

• The specific method of calculating the settlement amount (the amount paid on cancellation) that might be needed on early termination
• The advantages and disadvantages of the forward-start type and the spot-start type (see the Term row of the table)
• That the level of the fixed rate was within a reasonable range in terms of its effect of limiting the risk of rising interest rates

The Supreme Court did not accept this and dismissed the client's claim. It gave the following four reasons¹³.

1. Whether this transaction is advantageous or disadvantageous depends only on whether future interest rate movements could be predicted. Its basic structure is simple, and it is not difficult to understand, at least for a business manager.
2. The bank explained the basic mechanism and also told the client that if the floating rate did not rise much, the burden would be heavier than paying the interest on the loan, so it basically met its duty to explain.
3. The proposal stated that early termination was in principle not possible and that a settlement amount might be payable if the bank agreed to a cancellation. It is hard to say there was a duty to explain even the specific method of calculating the settlement amount. The bank explained both the forward-start and spot-start types, and the client chose by itself.
4. Whether the fixed rate level is reasonable is, given that the transaction is simple, a matter of the client's own responsibility.

The judgment addressed the explanation of the transaction in this case. It rested on the contents of the proposal, the client's business, and the simplicity of the transaction, and it does not say that the same conclusion applies to every sale of an interest rate swap.

The UK review of interest rate hedging products

Interest rate hedging products (IRHPs) were products often sold as protection for loans against interest rate changes, and they include interest rate swaps and caps¹⁴.

The UK Financial Services Authority (FSA) examined their sales in 2012 and 2013. The FSA reported from its 2012 review that some banks had serious failings in selling IRHPs to small businesses. As a result, eleven banks agreed to review around 40,000 interest rate hedging products sold on or after December 1, 2001. The review covers certain "non-sophisticated" customers¹⁵.

The failings the FSA found in 2012 include the following¹⁶.

• Complex types of products were sold inappropriately to non-sophisticated customers.
• Exit costs were poorly disclosed.
• Banks failed to ascertain the customers' understanding of risk.
• Sales that were supposed to be non-advised strayed into advice.
• There was "over-hedging", where the amounts or duration did not match the underlying loans.

The FSA said that the seller's rewards and incentives were also a driver of these failings¹⁶.

The review proceeded as follows. On June 29, 2012, four banks, Barclays, HSBC, Lloyds, and RBS, announced that they would carry out a proactive redress exercise for customers and a review of past sales. On July 23, other banks announced that they would also review their sales on the same basis. The treatment differed by product. Non-sophisticated customers who were sold structured collars (a term from the FSA's report) were to be given redress automatically. For other products except caps, the bank would review the sale and decide whether redress was due. For caps, the bank would review the sale if the customer made a complaint during the review. For each bank, an independent reviewer approved by the FSA was appointed. When the bank and the reviewer disagreed, the reviewer's conclusion prevailed¹⁷.

The report of January 2013 (partly corrected in March) said that over 90% of the 173 sales examined in the pilot did not comply with one or more of the FSA's regulatory requirements. The FSA also wrote that, because the pilot covered a small number of relatively complex cases, this share may not be representative of the results of the whole review¹⁸.

Figure description

The timeline shows the key dates of the UK review of interest rate hedging products, oldest first. December 1, 2001 is the starting point of the products covered, not the date of an event. June 29, 2012, July 23, 2012, and January 2013 are the dates of the announcements and the report. The spacing in the figure does not represent the length of time between dates. It shows that the review moved from the banks' agreement, to its spread to other banks, to the pilot report.

The sophistication test determined which customers fell within the review. At first, a customer was deemed sophisticated if it met at least two of three criteria: turnover above 6.5 million pounds, a balance sheet total above 3.26 million pounds, and more than 50 employees. In the pilot, the FSA noticed that under this test farmers and bed and breakfast businesses with a lot of real estate or machines were excluded, while small subsidiaries of large corporate groups could be included, and it amended the test¹⁹.

Lessons from the cases

Although the issues differ, the three cases show three perspectives for examining a sales problem.

On explanation, Article 37-3 of the Financial Instruments and Exchange Act requires a financial instruments business operator, etc. that intends to conclude a contract to inform the client before the contract of matters such as the risk of loss (paragraph 1). Paragraph 2 requires that, except for some matters such as the risk of loss, the matters to be provided be explained in a form the client can understand. The explanation is given by the method and to the extent necessary for understanding, in light of the client's knowledge, experience, financial situation, and purpose in entering the contract. The excluded matters are not subject to the explanation in paragraph 2 and are only to be provided under paragraph 1²⁰.

On suitability, the Financial Instruments and Exchange Act provides that a financial instruments business operator, etc. must not solicit in a way that is inappropriate in light of the client's knowledge, experience, financial situation, and purpose in entering the contract²¹.

A solicitation that deviates markedly from the suitability principle is also unlawful under civil law. The 2005 judgment cited provisions such as the Securities and Exchange Act before its 1998 amendment and the rules of the securities industry association (the industry body of securities companies). The judgment said that these are rules by which the government regulates securities companies (business regulation under public law) or rules that an industry body sets for itself (self-regulation). It still held that when a representative solicits in a way that deviates markedly from the suitability principle, the solicitation is also unlawful under tort law⁵.

Conduct Risk covers conflicts of interest. On pay structure, the UK report cited it as a driver of the failings, as the table above shows. In Japan, Article 36 of the Financial Instruments and Exchange Act is a provision to prevent client interests from being unjustly harmed by transactions of the firm or its group. The article does not use the words "conflict of interest", but a Type I financial instruments business operator that conducts securities-related business, among others, must set up systems for managing information and monitoring its business²².

In all three cases the decisions were made for a specific combination of product and client. Even for the same product, the degree of explanation and the suitability judgment change if the client's experience or business size differs. The cases above are material for seeing what can become a problem in sales practice. They are not an evaluation of any specific sale or financial institution.

Proposals and Explanations covers the procedure for explaining to clients.

What this article does not cover

This page does not cover later changes in law, the final outcome of the UK review, or how structured collars work.

Notes

1. "民法" (Civil Code, in Japanese), Article 709. An official English translation is available as "Civil Code" in Japanese Law Translation, https://www.japaneselawtranslation.go.jp/en/laws/view/3494/en. ↩

2. Supreme Court of Japan, First Petty Bench, judgment of July 14, 2005 (2003 (Ju) No. 1284, claim for damages) (in Japanese), the main text (page 1) and reasons 4(3) (pages 8–9) and 5 (pages 9–10). The result is "破棄差戻" (quashed and remanded). ↩ ↩²

3. The same judgment, reasons 1(2) to (5) (pages 1–5). The facts of the client's trading are those the judgment presents as established by the lower court. The start of option trading is on page 3 (イ), the loss in the third round on page 4 (エ), and the loss in the fourth round on page 5 (オ). ↩

4. The same judgment, reasons 4(2) (page 7) and the supplementary opinion (page 10). ↩

5. The same judgment, reasons 3 (pages 5–6; the lower court's decision) and 4(1) (pages 6–7). The text's "securities industry association (the industry body of securities companies)" is not from the judgment. It is based on the Japan Securities Dealers Association, "協会の概要" (About the association, in Japanese; retrieved in October 2026), "全国の証券会社を構成員とする社団法人" (a corporation whose members are securities companies nationwide). ↩ ↩² ↩³

6. The same judgment, reasons 4(2) (pages 7–8) and 4(3) (pages 8–9). ↩

7. The same judgment, the supplementary opinion of Justice Chiharu Saiguchi (pages 10–11). ↩

8. Supreme Court of Japan, First Petty Bench, judgment of March 7, 2013 (2011 (Ju) No. 1493, claim for damages) (in Japanese), the main text and reasons 1 and 4 (pages 1 and 5–6). ↩

9. The same judgment, reasons 2(1) (page 1). ↩

10. The same judgment, reasons 2(4) (page 4). ↩

11. The same judgment, reasons 2(5) (page 4). ↩

12. The same judgment, reasons 2(2) (page 2). ↩

13. The same judgment, reasons 3 (pages 4–5; the lower court's decision) and 4 (pages 5–6). Reasons 1 and 2 are on page 5, 3 on pages 5–6, and 4 on page 6. ↩ ↩²

14. Financial Conduct Authority, "Interest rate hedging products (IRHP)" (retrieved in October 2026; last updated March 20, 2023), "Background to the sales review". ↩

15. Financial Services Authority, "Interest Rate Hedging Products: Pilot Findings" (March 2013 version), 1 "Executive Summary" (page 3). ↩

16. The same report, 2 "Background" (page 5). ↩ ↩²

17. The same report, 2 "Background" (pages 5–6) and 3 "Findings from the pilot", "Independent reviewers" (page 8). ↩

18. The same report, 1 "Executive Summary" (page 3; footnote 2 records the correction of March 6, 2013) and 3 "Findings from the pilot" (page 7). ↩

19. The same report, 4 "How the review will be conducted", "Sophistication test" (pages 10–11). ↩

20. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 37-3, paragraph 1, item 5 and paragraph 2. ↩

21. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 40, item 1. ↩

22. "金融商品取引法" (Financial Instruments and Exchange Act, in Japanese; English translation: Japanese Law Translation), Article 36, paragraphs 1 and 2. ↩