The Securities and Exchange Law (the SEL) of Japan will soon be amended and renamed the Financial Instruments and Exchange Law (the FIEL). The FIEL provides an entirely new regulatory framework and will impact private investment funds targeting Japanese real estate in that trust beneficial interests (commonly used in real estate transactions) will now be deemed to be securities and various activities involved in establishing or managing those funds will become subject to registration requirements.

Draft cabinet orders, ministry ordinances and guidelines under the FIEL were made available for public comment on April 13 2007. The final cabinet orders, ordinances and guidelines, which should reflect public comments, together with certain views of the Financial Services Agency (the FSA), should be made public in late June or early July 2007. The FIEL legislation is expected to come into effect in September 2007. This article is based on the draft cabinet order, ministry ordinances and guidelines.

The GK-TK structure

It is common practice in Japan for a private real estate fund to be structured in a so-called GK-TK structure, as illustrated in Chart 1. In a GK-TK structure, the fund is formed as a limited liability company (godo kaisha) (the SPC), which is established to acquire and hold trust beneficial interests in real estate. For tax reasons, and to avoid registration under the Real Estate Specified Joint Enterprise Law, an investment in Japanese real estate is commonly made through an acquisition of trust beneficial interests in real estate, rather than an outright purchase of the real estate. The SPC obtains necessary financing through debt (usually loans) and tokumei-kumiai (TK) investments. A TK investment is made pursuant to a tokumei-kumiai agreement entered into between the SPC, as the TK operator, and each investor. A TK is a statutory category of partnership and is a commonly used structure for equity-like investments in private real estate funds.

The SPC often retains an asset manager, who takes a lead role when the SPC acquires, manages and sells its assets, particularly trust beneficial interests in real estate.

Another common structure is the one using a TMK (tokutei-mokuteki-kaisha). The FIEL registration regulation will not apply to a TMK (although the registration requirements will apply to its advisor in the same way as they would in a GK-TK structure).

Chart 1: GK-TK investment structure

Registration requirements under the FIEL

The FIEL defines and regulates financial instruments business, classifying it into four categories:

Type I financial instruments business includes: the sale and purchase, brokerage and handling of public offerings and private placements of highly liquid securities such as stock and bonds (defined as Type I securities); the underwriting business; the business of operating a proprietary trading system (PTS); and the securities custodian business.

Type II financial instruments business includes: conducting public offerings and private placements of interests under a collective investment scheme (CIS), such as TK interests or other partnership interests (known as a direct offering); and the sale and purchase, brokerage and handling of public offerings and private placements of relatively illiquid securities (defined as Type II securities) such as trust beneficial interests and CIS interests.

Investment advisory business includes an advisory service where an adviser provides, for a fee, its client with advice on the value of securities or investment decisions based upon an analysis of financial instruments, but where the adviser is not given the discretion and authority to make investments on behalf of its client.

Investment management business includes: an investment management service where a manager has discretion to manage its client's funds and other assets by investing in securities and/or derivative transactions in accordance with investment decisions based upon an analysis of financial instruments (a discretionary investment management service); and managing funds and other assets contributed by CIS interest holders principally by investing in securities and/or derivative transactions in accordance with investment decisions based upon an analysis of financial instruments (a self-investment management business).

If an entity conducts any of these businesses, it must be registered under the FIEL (a registered person is called a financial instruments firm). The requirements for registration vary depending on which business it will conduct. (The business of operating a PTS requires approval, not registration.)

Registration of the SPC

Self-investment management business

Under the SEL, no licence or registration has been required for the SPC to manage funds contributed by TK investors in the GK-TK structure targeting trust beneficial interests in real estate. Under the FIEL, the SPC would likely need to register to conduct the investment management business because it manages funds contributed by TK investors by investing principally in trust beneficial interests, which will now be considered securities. The SPC's business would constitute self-investment management business. However, three exemptions are available under the FIEL by which the SPC might be able to avoid registration.

Exemption 1 – QII-targeted funds

The SPC will not need a registration for the investment management business and will only need to file a simple notification to the prime minister, provided the TK investors contributing to the SPC: (a) include at least one qualified institutional investor (QII, as defined under the FIEL) and do not include 50 or more non-QIIs; and (b) are not (i) a CIS operator (such as a TK operator) who obtains investments from any non-QII, (ii) a TMK whose securities are held by any non-QII, or (iii) a special purpose company whose issued bonds, stock or other securities are held by any non-QII (collectively, non-QII tainted entities). If the CIS operator is a limited partnership or limited liability partnership, and the aggregate of its non-QII investors and the SPC's non-QII investors is less than 50, it will be excluded from (i) above.

Chart 2: TK investment structure - QII-targeted fund

Chart 2 shows how the SPC can qualify for this exemption for QII-targeted funds as long as none of its QII investors or non-QII investors is a non-QII tainted entity. For instance, the SPC cannot enjoy this exemption if any of its QII investors obtains a TK investment from a non-QII.

Under the SEL, QIIs have been mostly limited to certain types of Japanese financial institutions, such as banks and insurance companies. The FIEL will expand the definition of QII so that, among other things, Japanese or non-Japanese legal entities holding securities worth ¥1 billion ($800,000) or more may qualify as QIIs if they make a filing designating themselves as such.

Exemption 2 – Delegation of investment management authority

The SPC would also be entitled to an exemption from the investment management business registration if it delegates its entire authority over investments made for the benefit of the TK investors to a financial instruments firm registered for investment management business (more specifically, a discretionary investment management service), and that firm notifies the FSA or other relevant authorities of certain matters before the execution of TK agreements, and certain other requirements are met.

Exemption 3 – Two-tier TK structure

There is a special exemption that applies only to a two-tier TK structure to invest in real estate trust beneficial interests (see Chart 3). The SPC would be exempt from the investment management business registration if: (a) there is only one TK investor (the master fund in Chart 3) contributing to the SPC; (b) the master fund is also a TK operator that obtains TK investments from investors and has made a notification for QII-targeted funds or is a registered financial instruments firm; and (c) the master fund notifies the FSA or other relevant authorities of certain matters before executing the TK agreement between the SPC and the master fund.

Private placement of TK interests (direct offering)

Under the SEL, the SPC would not need a licence or registration to conduct a direct offering of TK interests. Under the FIEL, if the SPC conducts a direct offering, it will need to register, as the offering will constitute a Type II financial instruments business.

The SPC will be exempt from this registration requirement if the SPC's direct offering deals with at least one QII and fewer than 50 non-QIIs, none of which is a non-QII tainted entity, and the TK agreement provides for a certain restriction on assignments of TK interests. Then, the SPC will just need to file a notification for QII-targeted funds.

Also, the SPC will not need to register if it retains a registered financial instruments firm to handle the offering of the TK interests, and if the SPC is not involved in any activities for the offering.

Sale and purchase of trust beneficial interests

The sale and purchase of Type II securities will constitute Type II financial instruments business under the FIEL. So a literal interpretation of the FIEL would indicate that the SPC will need a registration for Type II financial instruments business to sell or purchase trust beneficial interests, unless the sale and purchase activities are deemed not to be a continuing business.

Chart 3: TK investment structure - two-tier TK structure

It has been generally understood that sales and purchases for purposes of one's own investments, or without targeting the public, would not constitute securities business regulated under the SEL. If this interpretation is still valid under the FIEL, an SPC that sells or purchases trust beneficial interests for its own investment purposes should not need registration. We should pay attention to the FSA's views, which might be indicated together with the final cabinet orders and ordinances.

There is a clear exemption from registration for the sale of trust beneficial interests, which will be available only if the SPC delegates all the sales activities to a registered financial instruments firm and the SPC is not involved in any activities for the sale. This exemption, however, does not apply to purchases of trust beneficial interests.

Practical considerations

As a practical matter, it would be impossible for an SPC, which is essentially a paper company, to meet the requirements for registration because registration requires a certain level of human resources or organization to conduct the business and would take time to be completed. So when structuring an investment fund, it is crucial to make sure that the SPC is free from any registration requirements.

Registration of the asset manager

Under the SEL regulations, no licence or registration is required for an asset manager to provide investment advisory services or asset management services to an SPC holding trust beneficial interests in real estate, although it is required to register to provide investment advisory services to a TK investor contributing to the SPC (that is, a master fund in a two-tier TK structure; see Chart 3) under the Investment Advisory Business Law or to broker the sale of trust beneficial interests on behalf of the SPC under the Trust Business Law. (The Investment Advisory Business Law will be merged into the FIEL. Also, the Trust Business Law's registration requirement will be replaced by that for the Type II financial instruments business under the FIEL and the relevant provisions of the Trust Business Law will be deleted.)

Under the FIEL, an asset manager would probably need to register for investment advisory business or investment management business (for discretionary investment management services), and the Type II financial instruments business. Although certain exemptions from registration are available to the SPC, no such exemptions are available to an asset manager who provides any regulated businesses.

Registration for investment advisory business/discretionary investment management service

Given that an asset manager will provide advisory services concerning the value of trust beneficial interests or investment decisions based upon the analysis of trust beneficial interests, and the SPC pays a fee to the asset manager in return for the advice under an advisory agreement, the asset manager's advisory services at least constitute the investment advisory business.

If an asset manager is given the discretion and authority to make investment decisions on behalf of the SPC based on its analysis of trust beneficial interests, these services will constitute investment management business (a discretionary investment management service). The requirements for registration and other regulatory burdens are much stricter for investment management business than those for the investment advisory business. For example, for the investment management business, the asset manager is required to have enough human resources and organization to appropriately conduct the business, and to be capitalized at ¥50 million or more. Also, once the asset manager is registered for the investment management business, the businesses in which it can engage is limited to the extent permitted under the FIEL.

Despite this, the distinction between investment advisory business and investment management business (discretionary investment management service) is not clear-cut and depends on the circumstances in each particular structure. Based upon the information obtained so far, they can be distinguished as follows:

• If the SPC is deemed to have the capacity necessary to make investment decisions (more specifically, to make decisions on the sale or purchase of trust beneficial interests) independently from the asset manager's advice, the asset manager's advisory services will constitute investment advisory business.
• If the SPC is not deemed to have this capacity, the asset manager's advisory services will constitute investment management business.

For example, if the SPC's decision as to whether to follow the asset manager's advice is subject to the TK investors' consent, the SPC would likely be deemed to have the necessary capacity, so its asset manager would need only register for the investment advisory business.

Registration for Type II financial instruments business

Private placements of TK interests

If the SPC retains an asset manager, instead of a securities firm, for private placements of TK interests, the asset manager would be required to register for Type II financial instruments business.

Under the SEL, only registered securities companies may handle private placements and it has been common practice that an asset manager does not deal with private placements. The FIEL, however, loosens the requirements for registration for Type II financial instruments business as compared with those for the securities business under the SEL, and so many asset managers are expected to register for Type II financial instruments business to be able to handle private placements of TK interests on behalf of the SPC.

Brokerage of sale and purchase of interests

As part of its asset management services, an asset manager often takes the initiative in connection with sales and purchases of trust beneficial interests on behalf of the SPC. These activities will be deemed as brokerage services with respect to Type II securities and so the asset manager would need to register for Type II financial instruments business.

Transitional measures

Many transitional measures are provided for in the FIEL and its related laws. Chart 4 outlines the transitional measures that will be available to an SPC or an asset manager.

Author biographies

Eriko Ozawa Mori Hamada & Matsumoto Eriko Ozawa is a partner at Mori Hamada & Matsumoto. Her practice focuses on structured finance and real estate, particularly real estate finance and securitization. She is admitted to the Bar in Japan (1998) and New York (2002). She graduated with an LLB (1996) from the University of Tokyo and an LLM (2001) from New York University School of Law. Masumi Nishi Mori Hamada & Matsumoto Masumi Nishi is an associate at Mori Hamada & Matsumoto. Her practice focuses on structured finance, private equity and venture capital. She is admitted to the Bar in Japan (2004). She graduated with an LLB (2003) from the University of Tokyo.