The Financial Instruments and Exchange Law of Japan (the FIEL) will take effect on September 30 2007 as an amendment to the existing Securities and Exchange Law of Japan (the SEL) and related laws. A stated purpose of the FIEL is to regulate various types of financial instruments for investment in order to protect customers. However, the FIEL will also require structured finance practitioners in Japan to consider several important points. Below is an outline of those points.

Scope of "securities" expanded

Broadly speaking, all trust beneficial interests (TBI) will be regarded as securities for the purpose of the FIEL. Therefore, marketing and placement activities for the TBI will have to be made within the framework of the FIEL. Although a trust may not change the substance of the entrusted assets, the TBI is given a position under the FIEL, which may not be given to the entrusted assets by themselves. This may result in an unexpected increase in the regulatory burden of complying with the FIEL if people do not fully appreciate the difference of the TBI and the entrusted assets.

Similarly, all tokumei kumiai interests (TK), partnership interests, limited partnership interests, interests in Japanese Limited Partnership Structures (LPS) or any other similar contractual rights whether governed by Japanese law or foreign law will be regarded as securities for the purpose of the FIEL (these are often called collective investment schemes in relation to the expansion of the scope of the FIEL). The definition of the collective investment scheme is broad enough to include any right to receive any distribution of profit or assets out of any business which manages or invests monies contributed by investors and accepted by the general partners. Substance matters in deciding if a right is that of the collective investment scheme. This definition is expansive and comprehensive. This is a dramatic legislative change from the traditional limited list of securities to an open-ended definition. The reason for this change is to apply the rules of the FIEL to various types of investment instruments.

The expansion of the definition of securities means that the scope of business activities which must comply with the FIEL will expand. For example, marketing and soliciting securities may be done only a person who is duly registered for the financial instruments business under the FIEL.

Derivatives regulated by the FIEL

The FIEL generally covers derivative transactions as well as securities transactions. Transactions covered by the FIEL include not only derivatives related to securities but also derivatives related to other financial instruments, and the FIEL covers derivatives that are transacted on a Japanese or foreign exchange or over the counter.

There are four categories of the Financial Instruments Business registration under the FIEL: Type I Financial Instruments Business, Type II Financial Instruments Business, Investment Advisory Business and Discretionary Investment Management Business.

Registration for Type I Financial Instruments Business is required for: (i) marketing type I securities, defined in article 2, paragraph 1 of the FIEL as securities with more liquidity such as government bonds, corporate bonds, shares, unit trusts and other traditional securities, (ii) conducting underwriting activities of all securities, (iii) conducting PTS (proprietary trading system) business, (iv) conducting derivative business over type I securities on exchanges, and (v) conducting over-the-counter derivative business. The requirements for the registration of Type I Financial Instruments Business are the most rigorous of the four categories because it affects so many investors and exposes the business to risk which needs to be more closely managed. Type I Financial Instruments Business roughly corresponds to the typical business of current securities firms.

Registration for Type II Financial Instruments Business is required for: (i) marketing type II securities, which are defined in article 2, paragraph 2 of the FIEL as securities with less liquidity such as ordinary TBI, TK interests, limited partnership interests, Japanese LPS interests and the like (so-called deemed securities), (ii) placing as issuer newly issued TK interests, limited partnership interests, Japanese LPS interests and the like, (iii) conducting derivative business over type II securities on exchanges, and (iv) conducting derivative business over financial instruments other than securities on exchanges. The requirements for registration of Type II Financial Instruments Business is more relaxed than those for the Type I.

Registration for Investment Advisory Business is required to conduct advisory business on the value or the like of securities and other financial instruments. The requirements for the registration of Investment Advisory Business are also more relaxed than those for Type I Financial Instruments Business. However, as it is not necessarily clear whether a given piece of advice would, for the FIEL purposes, be regarded as related to the Investment Advisory Business (or instead partially or entirely related to another of the other three categories), especially when the TBI, the recourse assets of which are not financial instruments, is invested.

Registration for Discretionary Investment Management Business is required to conduct discretionary investment management business as to investment decisions over securities or any other financial instruments. The requirements to obtain a registration as a Discretionary Investment Management Business are the second most rigorous of the Financial Instruments Business registrations (those of the Type I Financial Instrument Business are the most rigorous). There are three sub-categories of Discretionary Investment Management Business. The first is that of the discretionary manager based on a discretionary investment management agreement. The second is that of the settler of unit trusts. The third is that of the general partners of partnerships, limited partnerships and the Japanese LPSs, operators of TKs, and persons with similar roles as to any other collective investment scheme.

The first two sub-categories existed under the SEL. However any activities that fall within the third sub-category were not regulated under the SEL and are now included for the first time in regulated business by the FIEL.

One of the keys of the FIEL is to understand that the registration requirements of the discretionary investment manager (first sub-category) and that of the general partner (third sub-category) are different. For example, both a general partner of a limited partnership and an investment manager to that general partner are subject to the Discretionary Investment Management Business registration, but under different sub-categories.

The requirements to register as a Discretionary Investment Management Business include that the registrant be a stock company of at least ¥50 million in capital and minimum assets with a board of directors and a statutory auditor, unless committee systems are adopted, and with a competent compliance officer.

There are two exemptions that structured finance-related special purpose companies might want to utilize if they will engage in activities that would otherwise require registration as a Discretionary Investment Management Business under subcategory three.

First, the full delegation exception. Here the general partner or the TK investor in a collective investment scheme fully delegates its management power to a person who is duly registered as a subcategory one discretionary manager for the Discretionary Investment Management Business with certain prior notification requirements to the Japanese government. This exemption will match the investors' expectation to rely on the expertise of an investment manager. This is available only under subcategory three.

Second, the QII exemption. This can be used if the limited partners or TK investors in the collective investment scheme comprise at least one qualified institutional investor under the FIEL (the QII) and up to 49 other non-QII investors, with certain prior notification requirements to the Japanese government and applicable selling restrictions. It is available only under subcategory three. Importantly, a fund-of-funds with investors who are not QII generally jeopardize the availability of the QII exemption. However, if the mother fund is formed by the Japanese LPS, there is a possibility that the QII exemption is still available. The reason for this approach is that the Japanese LPS is established in accordance with a special Japanese law to establish and govern such entities, and organization and registration under such law is supposed to provide sufficient transparency. The Japanese LPS therefore provides a more flexible investment tool, but may not do so in cross-border transactions because it may create "permanent establishment" for tax purposes.

The QII include banks, securities firms, trust banks, discretionary trust companies and other financial institutions. Ordinary business corporations may become QII if they are registered with the Japanese government and if they invest in securities in the amount of at least ¥1 billion. Certain foreign investors may also become QII by registration with the Japanese government. Application for registration to become QII is only accepted in January and July of each year. If registered, QII status is given effective from the following March (if accepted in January) or from the following September (if accepted in July) for the next two years. That means that the earliest date on which a registrant could become a QII would be March 2008.

As noted above, the FIEL generally purports to protect investors in Japan. However, it also regulates the business of the investment adviser and the discretionary investment manager in Japan who provides services to non-residents. It is important to note that the general partner (those engaged in subcategory three of the Discretionary Investment Management Business) outside Japan may also be regulated by the FIEL if one or more limited partners exist in Japan. If a foreign general partner is required to be registered for subcategory three, that foreign general partner does not have to have an office in Japan, but would on be required to satisfy certain requirements, unless it qualifies for certain exemptions including the QII exemptions, which may or may not be practical. One additional exemption was created when, after the public comments to the proposed rules, the Financial Services Agency of Japan decided to exempt a foreign general partner from the registration requirement for the Discretionary Investment Management Business if all of the following are true: the number of limited partners in Japan is less than 10, every limited partner in Japan is a QII, and the total contribution by the limited partners in Japan does not exceed one-third of the total contribution of the fund.

Investment Advisory and Discretionary Investment Management Business

Conceptually, one way to distinguish the Investment Advisory Business and the Discretionary Investment Management Business is by the fact that the investment adviser in the latter (but not the former) has discretionary power. If there is any discretionary power given to the investment adviser, then that adviser must be registered for Discretionary Investment Management Business. Viewed from the other side, Investment Advisory Business always requires that the relevant customer make investment decisions. This rule applies to both type I securities and the type II securities.

However, it may not be easy to demonstrate that the relevant customers actually make investment decisions in structured finance transactions because, in reality, there are no clear criteria to determine the source or provenance of a given investment decision. For example, a customer who has received investment advice from an adviser may make the decision that complies with that advice. If that customer really makes his own investment decision without delegating any power to the investment manager, the manager's role would be limited to that of the investment adviser and is not the role of the discretionary manager. However, it may or may not be practical for the customer to make its own investment decision because that decision requires consideration of various factors and balancing the needs of the customer's investors. This is particularly the case where the customer is a special purpose company with bankruptcy-remote status; such a customer would often have a neutral or nominee director and would not have any employees. If this customer is faced with having to make a difficult or sensitive investment decision, it is unlikely (given the shell nature of the special purpose company) that the director or employee (if any) in charge at the customer would have sufficient skill, knowledge or experience to make investment decisions.

The alternative would be for the director and employee to be directed by the investors to make the investment decision, but that may be time-consuming. Further, additional complexity when a TK is the relevant collective investment scheme may arise, because the TK investor is generally expected to be silent as to the business of the TK operator. Although the TK investor may not be prohibited from communicating its desire to the TK operator, the investor cannot control the business of the operator. The fact that the TK keeps its legal nature under the Commercial Code of Japan is often the concern of the debt financers and tax advisers who give tax opinions. Unfortunately, there is no clear guideline as to whether the TK would lose its nature as such if the TK investor is allowed to speak up. This is also a question of fact finding (for example, the issue of whether or not certain actions constitute "control or management" of the business of the TK operator would be fact-intensive).

Bear in mind that the examination of what occurs in reality and the substance of the transaction, over the form of legal documents is important. Even when the contract provides that it is an advisory agreement, the factual circumstances and actions of the parties might be such that the agreement is considered a discretionary management agreement that cannot be made without the registration of the Discretionary Investment Management Business.

Self-placement of instruments

Any placement activities by directors or employees of the general partner or the TK operator in the collective investment scheme require the registration of the Type II Financial Instruments Business. Such activities are regarded as something more than ordinary financing through the issuance of shares or bonds. However, it may not be practical for special purpose companies to be registered. In order to avoid the registration requirement, the general partner or the TK operator should delegate all of the placement activities to a firm that is duly registered for the Type II Financial Instruments Business and should not engage in such activities by itself. Another possible solution is to use the QII exemption for the placement, which requires satisfaction of certain selling restrictions in addition to the eligibility requirements of QIIs and certain prior notification to the government.

Tai Koshu Sei

The concept of Tai Koshu Sei is intended to limit the scope of the activities which require the Financial Instruments Business registration under the FIEL. Activities that look as if they fall within the definition of Financial Instruments Business arguably do not require the registration of the relevant Financial Instruments Business on the part of the relevant person if there is no Tai Koshu Sei. Note that this element is not in the language of the FIEL itself. However, the Financial Services Agency takes the position that Tai Koshu Sei is necessary to constitute Financial Instruments Business. The Japanese phrase Tai Koshu Sei may be translated into English as "toward many persons". However, the biggest problem in the introduction of the concept of Tai Koshu Sei is that there is no established definition. This concept might be used when a transaction is made within very small and limited parties, which it is reasonable to everyone to kick out from the regulated field. In using this concept, however, careful attention is necessary because the Tai Koshu Sei concept is not written in the FIEL and because there is no established understanding of that term's meaning.

Specified investors

Under the FIEL, several obligations on marketing activities and other activities of persons registered for Financial Instruments Business under the FIEL may not apply when the customers in the relevant transactions are "specified investors", which includes QIIs and may include business corporations which elect to be treated as such. The election of QII status and non-QII status is very technical and needs to follow certain steps. In structured finance, special purpose companies would elect to be treated as QIIs in order to have more flexibility in the structuring.

The FIEL also has provisions for a transitional period. These provisions are very complicated and require careful attention.

Author biography

Tetsuya Itoh Anderson Mori & Tomotsune Tetsuya Itoh is a partner at Anderson Mori & Tomotsune with experience in the fields of structured finance, other finance transactions, commercial and corporate with coverage of regulatory affairs and asset transactions including real estate. Itoh has represented lenders, arrangers, agents, trustees, equity investors and originators. His involvement covers debt financing, equity investments, arrangement of funds, TMKs (a Japanese special purpose company for securitization), Reits, trusts and construction projects. Recently Itoh was involved in the setting up of several real estate funds. He is also involved in several corporate transactions, including M&A and acquisition finance. He advises financial institutions on both transactional and regulatory aspects of the law. Itoh has given various seminars and lectures regarding finance, structured finance, and M&A, with a focus on new legislation and most recent practice in finance and corporate transactions. Itoh is a graduate of the University of Tokyo (LLB, 1991) and the University of Washington (LLM, 1997). He is admitted to practice law in Japan (1993) and New York (1998). Anderson Mori & Tomotsune (formed from the merger of Anderson Mori and Tomotsune & Kimura on January 1 2005) is a full service corporate law firm, with roots dating back to 1952. It has over 200 Japanese attorneys. The firm is mentioned by legal periodicals as one of the leading Japanese firms in regard to banking and finance and capital markets matters, and Itoh has been individually mentioned as among the top lawyers in these fields.