In late 2006, the author wrote an article about the Financial Instruments and Exchange Law (the FIEL), summarising the implications of the Law from the perspective of foreign institutions investing in Japanese securities or dealing with Japanese investors or counterparties in financial transactions (see "Financial products regulation revamped" in the IFLR Guide to Japan 2007). In August 2007, after an intensive public comment process, the FSA promulgated the Cabinet Order and Cabinet Office Regulations (collectively, the "ordinances") stipulating detailed regulations to enforce the FIEL. The FIEL became effective as of September 30 2007. This article is intended to provide an update on the legal issues under the FIEL discussed in the earlier article summarising important regulations relating to those legal issues stipulated under the ordinances.

Registration requirements

Unless an exemption or exception is permitted under the FIEL, any person who engages in financial instruments business either in Japan or with Japanese investors or Japanese counterparties must be registered with the Financial Services Agency of Japan (FSA). Six classes of financial instruments businesses are subject to registration requirements under the FIEL

1. The first financial instruments business

This is traditional securities business. The ordinances have made it clear that the qualification requirements for this business under the FIEL remain substantially unchanged from those under the earlier Securities and Exchange Law (SEL). Underwriting businesses and securities-related over-the-counter derivative transactions are no longer subject to the licensing requirement. Only proprietary trading system business, which is the Japanese counterpart of alternative trading systems in the US and Europe, remains subject to the licensing requirement.

2. The second financial instruments business

a. What does this business category mean?

This business means securities business concerning securities with lower liquidity as well as listed derivatives products. This category also includes the self-offering of interests in a collective investment scheme by an organiser (including a general partner) of the collective investment scheme. In a nutshell, a collective investment scheme means an investment contract whereby a passive investor invests money into a business enterprise operated by another person in return for a share of the profit.

b. What does a self offering mean?

By way of an example, if a foreign organiser of a fund collects money from Japanese investors for the purpose of organising its investment fund, it constitutes a regulated self-offering requiring this registration. This is a new requirement, introduced by the FIEL, presumably based on a legislative intent to regulate active investment activities of the fund managers of collective investment schemes.

c. Exemption of a self offering to a qualified institutional investor (QII) plus less than 50 non-QIIs.

In the case where a self-offering of interests in a collective investment scheme is accepted by at least one QII and less than 50 non-QIIs, the offerer only has to file a notification, but does not have to be registered as a financial instruments firm.

3. Asset management business (Toshi Unyo Gyo)

This business category means investment trust management business, discretionary asset management business and self-management of a collective investment scheme and certain other funds investing primarily in securities and derivatives regulated under the FIEL. The registration requirement for the self-management of a fund is a new requirement. Similar to 2c above, there is a QII-related exemption for the self- management of a fund. By way of an example, if a general partner of the fund manages assets of investors who comprise of at least one QII and less than 50 non-QIIs, the general partner only has to file a notification, but does not have to be registered as a financial instruments firm.

For discussion on the applicability of this registration requirement to a foreign fund manager managing the assets of a Japanese investor, please see the paragraph below entitled "Regulations of Offshore Funds and Exemptions".

4. Investment advisory business

5. Agency or intermediary business for execution of investment advisory contracts or discretionary investment contracts

6. Financial instruments introducing brokerage business

Expanding the definition of "securities" and "derivatives"

1. The definition of "securities"

The FIEL has expanded the scope of the definition of securities by adopting a comprehensive definition of "a collective investment scheme". In addition to "securities" specified under the FIEL, the ordinances have designated a debenture issued by a school and a foreign CD as additional products covered within the definition of securities under the FIEL.

2. The definition of "derivatives"

The FIEL has expanded the definition of derivatives, consolidating the definition of derivatives under the SEL and those of the Financial Futures Act with the addition of some new derivatives products. In addition to the derivatives specified under the FIEL, the ordinances have designated derivatives involving variable indicators concerning natural phenomena, such as weather and terrestrial phenomena, and statistics concerning the national economy, such as GDP.

3. Certain derivatives transactions exempt from the regulation of the FIEL

The ordinances stipulate that the following derivatives transactions are exempt from the regulations of the FIEL: transactions (a) which are over-the-counter derivative transactions included in the definition of derivatives under the FIEL but not related to securities (defined as "Over-the-counter Derivative Transactions not Related to Securities"), including currency and interest rate swaps and credit derivatives, and (b) the counterparty of which is a financial instruments firm, Qualified Institutional Investors or a Japanese KK (kabushiki kaisha) or a foreign corporation comparable to a Japanese KK, having capital of no less than ¥1 billion (approximately $9 million). Accordingly, a foreign entity not registered with the FSA is able to engage in over-the-counter derivative transactions not related to securities with such qualified Japanese counterparties.

Overseas institutional investors

1. Professional investors v general investors

The FIEL has created a distinction between professional investors and general investors. Financial instruments firms transacting with professional investors are exempt from certain FIEL regulations that are primarily intended to provide investors with information important for investment consideration including information on the risks of the financial transaction contemplated.

The FIEL has also created two professional investor categories, further creating a distinction between permanent professional investors (namely, QIIs) and tentative professional investors who can opt out to become general investors for a less than one-year period if they wish to receive more investor protection. A tentative professional investor is able to exercise the option for each of the following four contract categories regulated under the FIEL; a contract for a securities transaction, a contract for a derivatives transaction, an investment advisory contract and an asset management contract.

2. Treatment of overseas institutional investors

The ordinances stipulate that overseas institutional investors, except where they fall within the definition of QIIs under the FIEL, are all classified as tentative professional investors, whereas overseas individual investors are all classified as general investors. Those overseas institutional investors are therefore able to opt out to become general investors and stay as general investors until the end of the less than one-year period set by the financial instruments firm at which they have an account. Before entering into any of the above-mentioned four categories of regulated contracts with a tentative professional investor for the first time, a Japanese financial instruments firm is obligated to notify the tentative professional investor of its right to opt out to become a general investor. Overseas institutional investors may from time to time receive such a notification letter from Japanese financial instruments firms.

Regulation of offshore funds and exemptions

1. FIEL regulation applicable to offshore funds

The registration requirement of the FIEL for asset management business extends to cover the management of an offshore collective investment scheme (for example, partnership) or the discretionary management by an offshore manager of third party clients' assets, which constitute an asset management business under the FIEL (Toshi Unyo Gyo), if the asset of a Japanese investor is involved under the management. However, as discussed below in this paragraph, in regard to an overseas fund operating in the form of a collective investment scheme, there are two exemptions from this registration requirement stipulated under the ordinances (the management of an investment trust set up outside of Japan lies outside of the scope of the FIEL registration requirement).

2. First exemption

First, to avoid undue extra territorial application of the registration requirements, the ordinances afford to an overseas fund operating in the form of a collective investment scheme an exemption from the registration requirement if (A) the Japanese investors holding interests in the fund comprise of less than 10 QIIs or certain other eligible entities specified under the ordinances and (B) the aggregate amount of such holdings by the Japanese investors constitutes less than one-third of the entire assets of the offshore fund.

3. Second exemption

Secondly, even if an offshore fund does not satisfy the requirement for the first exemption, the fund manager may still be able to take advantage of a provision under the ordinances that exempts the manager of a fund targeted primarily at QIIs. As far as the fund manages the assets of (1) at least one QII including a foreign institution that is a QII for the purpose of the FIEL and (2) less than 49 non-QIIs, the fund manager is not required to be registered and is simply required to file a report with the FSA providing certain prescribed information in relation to the fund manager and its activities.

Preferred structure and approach

1. Taking advantage of the exemptions

For an offshore fund manager who manages a fund in the form of a collective investment scheme, the fund structure that is the least onerous in terms of Japanese regulatory implications is an offshore fund in which Japanese investors comprise of less than 10 Japanese QIIs (or certain other eligible entities) taking advantage of the first exemption discussed above. Alternatively, the offshore fund manager may wish to set up a fund taking advantage of the second exemption discussed above.

However, if the offshore fund would like to set up an onshore Japanese business operation to engage in discretionary management of the assets of its offshore fund, or the assets of third party customers, it will need to apply for FSA registration to engage in discretionary asset management business.

2. The FSA's new registration requirements for discretionary asset management companies

Before the enactment of the FIEL, the Investment Advisory Business Law (the IABL) governed discretionary asset management business. Under the IABL, discretionary asset management business was subject to a licensing requirement as opposed to a registration requirement introduced by the FIEL. The application for the licence was a painstaking process, and many foreign fund managers viewed the licensing requirements as a practical impediment to engaging in the discretionary asset management business.

3. Qualification requirements for discretionary asset management business

The ordinances have made it clear that the qualification requirements for discretionary asset management business under the FIEL remain substantially unchanged from those of the former IABL, including the requirements for minimum capital and resources, as well as an appropriate compliance infrastructure. As was the case under the IABL, for example, only a Japanese KK having a board of directors as its governing body, or a foreign corporation comparable to such a Japanese KK, can apply for registration to engage in discretionary asset management business. Nonetheless, the application process for discretionary asset management business under the FIEL would be much less burdensome for the applicant. The change from a licensing requirement under the IABL to a registration requirement under the FIEL has had the effect of reducing the discretion of the FSA in the assessment of the qualifications of an applicant for discretionary asset management business.

Due to the complexity of the licensing requirement applicable to asset management business under the former IABL, there were offshore hedge fund managers who set up their Japan operations as the provider of only "investment advice" without applying for the required licence for discretionary asset management business. In light of the increased regulatory scrutiny of asset management business and enhanced compliance consciousness among institutional investors, I believe that this practice will cease to exist under the FIEL. However, one may need to consider possible tax implications. If the Japanese business operation is likely to have its overseas parent's fund(s) as the sole or primary customer, it may raise a permanent establishment issue that should be carefully examined by a Japanese tax adviser.

Regulation of securities transactions of overseas securities companies with Japanese investors

1. The FIEL and ordinances maintain the basic framework of the SEL

Under the FIEL, there is no substantial change from the SEL in the regulatory framework for securities transactions of overseas securities companies with Japanese investors. The FIEL maintains the exemption that was available under the former SEL applicable to securities transactions of foreign securities companies with QIIs and other sophisticated institutional investors.

The FIEL and ordinances also conceptually maintain the exemption available under the former SEL applicable to unsolicited securities transactions of foreign securities companies with Japanese investors in general. However, it is to be noted that under the ordinances such exemption to an unsolicited transaction is available only after the foreign securities company has received an order from a Japanese investor on an unsolicited basis.

2. Deregulations under the ordinances

Like the SEL, the FIEL excludes OTC securities derivatives transactions from the scope of the exemption of unsolicited securities transactions of foreign securities companies with Japanese investors other than the sophisticated investors. However, the ordinances have introduced an exception to this exclusion, enabling foreign securities companies to engage in unsolicited OTC securities derivatives transactions with a Japanese KK (kabushiki kaisha) having a capital of no less than ¥1 billion. This counterparty category is the same as a Japanese KK qualified to engage in over-the-counter derivative transactions not related to securities exempt from the regulations of the FIEL.

In addition, there is another exemption where a registered Japanese financial instruments firm is involved as an intermediary or introducing broker for a foreign securities company and the foreign securities company by itself does not engage in solicitation. The ordinances enable the foreign securities company to enter into certain securities transactions including, if the counterparty belongs to the above qualified KK category, OTC securities derivatives transactions.

3. What is solicitation?

Solicitation is always an evasive concept and difficult to define. A foreign firm that wishes to avoid being deemed to have engaged in solicitation of business from Japanese investors other than the sophisticated investors, may wish to consider the following policies:

a. Do not send e-mail to investors unless their addresses are outside of Japan.

b. Do not place an advertisement or provide on-line trading services in the Japanese language on its web site.

c. Place a legend on its web site offering on-line trading services to the effect that Japanese resident investors are restricted from using the on-line trading services.

d. Set up procedures to decline opening accounts and use of trading services by Japanese investors by blocking their access if the investor enters an address in Japan.

Increased interest in the activities of overseas investors

1. Japanese brokers are expected to cooperate with the enforcement agency's request for information on overseas end customers

In today's markets, the trading activities of overseas investors are a matter of considerable interest to the Securities Exchange and Surveillance Commission (SESC), the Japanese enforcement agency. To collect information on trading activities, the SESC regularly sends inquiries to FSA-regulated financial instruments firms concerning the orders of their customers for particular stock during a time period in issue, including the orders of the end customers of their overseas affiliates executed by the FSA-regulated financial instruments firms.

To obtain enough information from the financial instruments firms on the end customers of their overseas affiliates who route their orders through the overseas affiliates, the SESC has made it clear that it expects Japanese financial instruments firms to set up a trade surveillance programme that allows them to review the identity of the end customers and their trade history. Such expectations of the SESC and FSA are clearly stated in the Inspection Manual of the SESC and the Guidelines of the FSA for the supervision of financial instruments firms.

Overseas fund managers will receive from Japanese financial instruments firms, or their overseas affiliates at which they have a trading account, an increasing number of requests for their consent to the disclosure of their trade information in response to the inquiries of the SESC.

2. How should overseas fund managers respond to requests for disclosure of their trading information?

Inquiries from the SESC do not necessarily imply the commencement of a SESC investigation into any illegal activity. The SESC frequently sends inquiries and information requests to financial instruments firms just for information on the trading activities of particular stock in which the SESC is interested. The SESC also sends inquiries when the trading activities of a particular stock are irregular or questionable and require further review, including the identity of the persons who placed orders for the stock.

Obviously, overseas fund managers are not subject to the jurisdiction of the Japanese SESC. However, overseas fund managers may wish to carefully re-evaluate their policy concerning their responses to those regulatory inquiries requesting trading information of their orders. If the fund managers have business operations in Japan or collect money from Japanese investors, they may wish to make it a general rule to permit disclosure of their trading information in response to requests from the Japanese SESC.

Author biography

Akio Kawamura Nishimura & Asahi Akio Kawamura is counsel at Nishimura & Asahi, the largest law firm in Japan. His main areas of practice are banking, capital markets, asset management, corporate crisis management, civil and commercial disputes, and other specialised disputes. He is a graduate of Kyoto University (LLB, 1980) and the University of Pennsylvania Law School (LLM, 1986), and was admitted to the Bar in Japan in 1982, and New York in 1987. His professional experience includes working at White & Case (New York, between 1986 and 1987), Nikko Citigroup (formerly Salomon Brothers Asia, between 1987 and 2004) and Asahi Koma Law Offices (between 2004 and 2007). Kawamura has authored a number of articles in English and Japanese for various domestic and international legal publications, such as "Q&A: All about the Corporation Law," Chuo Keizai-sha, August 2005; "How the Corporation Law affects Foreign Companies," IFLR Guide to Japan, January 2006; and "Financial Products Regulation Revamped," IFLR Guide to Japan, January 2007.