Quiz: Client Protection

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5 questions to check your understanding of the chapter “Client Protection”. Choose an answer and select “Check answer” to see the answer and explanation. You can also open “Answer and explanation” to see the answer first.

1. Question 1

   In its judgment of July 14, 2005, the Supreme Court (First Petty Bench) considered whether a securities company's recommendation that a customer sell Nikkei 225 options was a tort violating the suitability principle. According to the judgment, when is a solicitation unlawful in tort law as well?

   1. A.When the customer lacks the knowledge, experience and ability to limit or avoid losses from selling, the solicitation is unlawful unless there are special circumstances
   2. B.When the risk common to selling as a type of transaction is large, the type's risk outweighs the customer's experience and assets, and the solicitation to sell is unlawful
   3. C.When the representative actively recommends a transaction whose risk is clearly excessive given the customer's wishes and circumstances, the solicitation is unlawful
   4. D.When the product is exchange-listed, it has already passed a review of its features, so the solicitation is normally not unlawful even if the customer has little experience
   Answer and explanation

   Answer: C

   The Supreme Court set this standard: if a customer is made to trade through a solicitation that departs markedly from the suitability principle, the solicitation is unlawful in tort law as well. The court looked not only at the risk common to selling as a type of transaction but also at the features of the product, such as the underlying asset and whether it is listed, together with the customer's investment experience, knowledge, intentions and assets.

   The first option is the lower court's view, which the Supreme Court did not accept. The second puts the risk of the transaction type above the customer's circumstances, which does not fit the judgment's approach. The fourth takes the product's listing into account but also looks at the customer's side, so it does not fit either. In this case the size of the customer's funds and the customer's trading experience were considered, and the solicitation was held not to be a marked departure.

   Learn more: Mis-Selling Cases

2. Question 2

   In its judgment of March 7, 2013, the Supreme Court (First Petty Bench) found no breach of the duty to explain by a bank that had offered an interest rate swap to a company. Which statement follows the reasoning of the judgment?

   1. A.The fixed rate level is something the bank should explain even for a simple transaction, but it explained the mechanism, so there is no breach
   2. B.The proposal described how early termination is handled, so it is hard to say the bank had a duty to explain the details of the calculation
   3. C.The bank explained only one of two types with different start dates and did not let the customer choose, but the transaction's simplicity was the reason a breach was denied
   4. D.The bank did not tell the customer of the burden if rates stayed low, but because the transaction is simple, there is no breach
   Answer and explanation

   Answer: B

   The Supreme Court described the transaction as a simple structure in which gain or loss depends only on whether one could read the movement of future interest rates. It then found that the bank had explained the basic mechanism, and that the proposal stated that early termination is in principle not possible and that a termination payment may arise if the bank agrees to terminate.

   The first option makes the reasonableness of the fixed rate level a matter for the bank to explain, whereas the judgment held it to be the customer's own responsibility. The third does not fit the fact that the bank explained both types and the customer chose for itself. The fourth does not fit the fact that the bank also told the customer of the risk if rates stayed low. The judgment does not apply the same conclusion to the sale of interest rate swaps in general. It is a judgment about the explanation of the transaction in this case.

   Learn more: Mis-Selling Cases

3. Question 3

   Under the Financial Instruments and Exchange Act, what measure must a Type I financial instruments business operator, such as a securities company, take in relation to a dispute resolution organization designated under financial ADR? Assume that registered financial institutions are not considered.

   1. A.Take measures to enter into a basic contract for the implementation of dispute resolution procedures with all of the designated organizations, and announce the name of each
   2. B.Even where a designated organization exists, setting up an internal system and rules is enough in place of entering into a contract
   3. C.The measure of entering into a contract is required only for cases in which a customer has applied for mediation, and the organization's name need not be announced
   4. D.Where a designated organization exists, take measures to enter into a basic contract for the implementation of dispute resolution procedures with one of them, and announce the organization's name
   Answer and explanation

   Answer: D

   Where a designated organization exists, the law requires a firm to take measures to enter into a contract with one of them and to make the name of its counterparty known. FINMAC (Financial Instruments Mediation Assistance Center) was designated in 2011, and FINMAC itself states that this obligation is performed toward it.

   The first option does not fit the fact that the law requires a contract with one organization, not with all of them. The measure of setting up an internal system and rules in the second option applies only where no such designated organization exists. The third does not fit the fact that the measure of entering into a contract is required whether or not any individual customer has applied, and that the law also requires the organization's name to be announced. The contract also includes the term that the firm may not refuse a request from the organization or the dispute resolution committee member without a justifiable reason.

   Learn more: Complaints and Dispute Resolution (FINMAC)

4. Question 4

   A customer applied for mediation at FINMAC, but the dispute resolution committee member ended the procedure on the ground that there was no prospect of settlement and notified the customer who had applied. Which statement matches the Financial Instruments and Exchange Act on the postponement of completion of prescription?

   1. A.If the customer files suit within one month of the day of notice on the claim that was the subject of the procedure, the suit is treated as filed at the time the claim was made in the procedure
   2. B.If the customer files suit within four months of the day of notice on the claim that was the subject of the procedure, the suit is treated as filed at the time the claim was made in the procedure
   3. C.There is no deadline for filing suit, and whenever the customer sues after the notice, the suit is treated as filed at the time the claim was made in the procedure
   4. D.If the customer files suit within one month of the day of notice, the financial institution is obliged to follow the settlement proposal presented in the mediation
   Answer and explanation

   Answer: A

   When mediation ends without settlement, the deadline after which the treatment of prescription changes is one month from the day of notice. If the claim dealt with in the procedure is sued on within that time, then for the postponement of completion of prescription the suit is treated as filed when the claim was made in the procedure.

   Four months is the upper limit of the period for which a court can stay an existing lawsuit on the parties' joint application, or the period FINMAC aims for in settling a mediation. It is not a deadline for prescription. Treating the deadline as nonexistent also differs from the rule. The fourth option does not fit the fact that filing suit only determines how the postponement of completion of prescription is treated and creates no obligation to follow the settlement proposal. The obligation to accept applies only to a special conciliation proposal, and not to one the customer does not accept, among other exceptions.

   Learn more: Complaints and Dispute Resolution (FINMAC)

5. Question 5

   The capital adequacy notice defines operational risk. Based on how the Financial Services Agency described conduct risk in October 2018, which statement about how the two relate is incorrect?

   1. A.The regulatory definition of operational risk includes legal risk and excludes strategic risk
   2. B.Some prudential supervisors regard conduct risk as part of operational risk
   3. C.Conduct risk falls entirely within the regulatory definition of operational risk
   4. D.Conduct risk also covers acts that violate social norms where the law sets no rules
   Answer and explanation

   Answer: C

   The incorrect statement is the third option. The notice includes legal risk in the definition of operational risk and excludes strategic risk and reputational risk. The Agency lists adverse effects on user protection and on market fairness and transparency as bad outcomes of conduct risk, and adds cases in which the institution's own reputation is damaged even without actual harm. Because adverse effects on reputation are excluded from the definition, the two have parts that overlap and parts that do not.

   The first option matches the notice's definition, which includes legal risk and excludes strategic risk and reputational risk. The second matches the fact that prudential supervisors regard conduct risk as part of operational risk, and it describes the side where the two overlap. The fourth matches the fact that the Agency also gives as examples acts that violate social norms where the law sets no rules.

   Learn more: Conduct Risk