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Japan – Tokyo High Court Judgment Highlights Issues To Be Considered By International Financial Institutions.

16 February, 2015


Legal News & Analysis – Asia Pacific – Japan – Corporate/M&A


In this article, we consider a recent Tokyo High Court judgment which may be of interest to financial institutions and investors operating in Japan.




TFK Corporation (“TFK“, formerly Takefuji Corporation) brought proceedings against Merrill Lynch Japan Securities Co., Ltd. (“MLJ“) and Merrill Lynch International (“MLI“, together the “Respondents“) for damages of approximately JPY 29bn. Although TFK’s claims were rejected at first instance by the Tokyo District Court, leave to appeal was granted, and a judgment partially in favour of TFK was handed down by the Tokyo High Court on 27 August 2014.


Here we look at some of the key take away points for financial institutions operating in Japan as well as investors in light of the Court’s findings, including:


  • the requirement for Japanese language translations of all English documents regardless of the investors’ international business and experience;
  • treatment of sophisticated investors as lay/retail investors;
  • arbitrary “date of no return” in relation to due diligence periods; and
  • the requirement for explanations to be delivered in a consistent manner and at a consistent level of detail.


Background To The Dispute


Around November 2006, TFK planned to effect an in-substance defeasance of corporate bonds issued on 5 June 2002 and requested MLJ to propose a scheme.1 MLJ’s proposed scheme involved Rated Index-Linked Limited Recourse Secured Fixed Interest Rate Credit-Linked Notes (“REDI Notes“).



After a series of meetings and documents having been provided to TFK, TFK purchased the REDI Notes for JPY 30bn from MLJ through JSF Trust and Banking Co., Ltd (“JSF Trust Bank“) in May 2007. The damages arose due to an early redemption of the REDI Notes which took place in February 2008.


TFK claimed that (i) the Respondents had breached their duty of care relating to the formation of financial assets with respect to the REDI Notes; (ii) MLI had breached its duty of care of a good manager as the calculation agent for the REDI Notes (a claim added at appeal stage); and (iii) the Respondents breached their obligation to provide explanations relating to the in-substance defeasance scheme. At first instance, the Tokyo District Court dismissed TFK’s claims.


The Tokyo High Court Judgment


The Court found against TFK on the alleged breach of the Respondents’ duty of care relating to the formation of financial assets with respect to the REDI Notes as well as the alleged breach of MLI’s duty of care as a good manager in its capacity as the calculation agent.


The Court did not deem that the REDI Notes were defective or deficient as financial assets or that they were completely unsuitable for the implementation of an insubstance defeasance. The Court also deemed that there was insufficient evidence to find that MLI had failed to perform calculations correctly.


Alleged Breach Of The Respondents’ Obligation To Provide Explanations Relating To The In-Substance Defeasance Scheme


The Court stated that the Respondents owed an obligation to provide TFK with explanations which were important for TFK to make a decision to purchase such financial assets.


In-substance defeasances of corporate bonds whose remaining terms exceeded ten years (as was the case here) had only occasionally been seen at that time, and the Respondents could not be considered to have sufficient experience in the REDI Notes that they proposed to TFK. In such circumstances, the seller of new financial products owed an obligation that required it to provide its client with explanations concerning the formation of the new products and the associated risks.


The Court appears to have found that TFK’s representatives did not have particularly detailed knowledge concerning financial transactions, based on the following comment made by TFK’s representative (found in an initial set of questions about the in-substance defeasance scheme sent to the Respondents): “these are elementary questions but please provide answers to them altogether”.


The Court also rejected the Respondents case that TFK had a vast amount of experience in carrying out complex international financial transactions because the Court could not find that TFK or its representatives had experience/knowledge specifically in relation to complex structured securities (such as REDI Notes).


These findings are surprising as the Court accepted that:


  • TFK was itself a large consumer finance business;
  • TFK had experience with complex international transactions (having procured capital through issuance of corporate bonds, established US Dollar credit facility commitments and taken part in in-substance defeasance transactions in the past with MLJ – albeit not with the REDI Notes); and
  • TFK’s representatives had both held managerial and executive positions within its finance department.


In effect, the Court chose to treat TFK as a lay investor rather than a sophisticated investor.


The Court then considered whether the Respondents’ representatives provided TFK’s representatives with detailed explanations of the risks arising from the in-substance defeasance scheme, and whether TFK’s representatives were able to have understood such explanations.


The Court deemed that the explanations provided were insufficient to allow TFK to simulate the in-substance defeasance scheme and to analyse the risks. Further, the Court noted that:


  • 17 April 2007 would be treated as the “date of no return” beyond which the Court considered any explanations given to be too late. The reasoning was that after this date TFK started negotiating with third parties (such as the trust bank), and the date was also the end of the due diligence period according to a schedule established on 12 January 2007;
  • the termsheet delivered on 17 April 2007 was only provided in English, no Japanese translation was provided and no verbal explanation was given; and
  • MLJ’s representatives initially provided thorough and detailed explanations of documentation, but failed to do the same in the latter stages.


The Court came to the conclusion that the Respondents breached their obligation to provide explanations concerning the insubstance defeasance scheme, and that the Respondents were liable to pay compensation to TFK for damages caused by a joint tort.


Contributory Negligence


Interestingly, the Court attributed 50% of the negligence to TFK and reduced damages to approximately JPY 14.5bn.


The Court stated that given the low cost of the proposed scheme, TFK should have presumed that it was a “high return, high risk” transaction. It noted that it was highly likely that TFK could have prevented the increase in the damages had it actively confirmed the nature of the REDI Notes with MLJ. The Court therefore found that TFK had also been negligent.


Even though neither party had expressly pleaded contributory negligence, the Court relied on Article 722 of the Civil Law to allow it to take into account the injured party’s negligence when calculating the compensation amount.


Points To Consider


The Respondents filed an appeal in the Supreme Court on 10 September 2014. Here, we consider the take away points arising out of this High Court judgment for financial institutions selling complex structured products in Japan, as well as for investors.


Requirement For Japanese Language Translations


Perhaps most importantly for international financial institutions operating in Japan on the sell side should ensure that all English documents are accompanied by Japanese translations. Such a requirement for Japanese translations is unprecedented, and the fact that the Court took issue with this is interesting, given it accepted:


  • TFK’s international experience;
  • that TFK was listed on the London Stock Exchange as well as the Tokyo Stock Exchange;
  • that TFK routinely released press releases in English for foreign investors; and
  • one of TFK’s main representatives had held executive positions in Australia.


Consideration Of The Investor’s Specific Representatives’ Experience


Sellers should ensure that sufficient explanation is provided to potential investors. The judgment indicates that the Court may treat sophisticated investors as lay/retail investors, unless the investor had experience in dealing with the specific financial product in the past (in this case the REDI Notes, even if the investor had prior experience with in-substance defeasance schemes). It is also notable that the Court focused on whether TFK’s representatives actually understood the explanations provided, rather than on TFK’s ability (as the corporate entity) to understand the explanations and make the decision to invest.


Arbitrary “Date Of No Return”


Sellers should make all the risks clear at the earliest opportunity, as the judgment appears to allow the Court to arbitrarily set a “date of no return”. The reasoning given by the Court on this aspect (see paragraph 3.9(a) above) can be considered unprecedented.


Nature And Consistency Of Explanations Given


The judgment also demonstrates that where detailed verbal explanations are initially given, there is a risk that merely asking the investor to confirm that they have read and understood the documentation in the latter stages of the transaction could be considered insufficient provision of information should this become an issue.


Investors should ensure that they actively engage with the sellers and request explanations for financial products that they may not be familiar with. Failure to do so may result in a finding of contributory negligence resulting in a significant reduction in the damages awarded.


End Notes:


1 An in-substance defeasance scheme is a scheme whereby a debt is deemed to be substantively repaid by way of establishment by the original debtor of an irrevocable trust which holds “risk free” assets to be appropriated solely to the repayment of the principal/interest of the debt, which is structured in such a manner as to prevent the accrual of additional payment obligations.


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For further information, please contact:


Peter Godwin, Partner, Herbert Smith Freehills
[email protected]

Dominic Roughton, Partner, Herbert Smith Freehills
[email protected]

David Gilmore, Partner, Herbert Smith Freehills
[email protected]

Elaine Wong, Herbert Smith Freehills

[email protected]

Christopher Hunt, Herbert Smith Freehills
[email protected]


Yosuke Homma, Herbert Smith Freehills

[email protected]


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