Disclosure reforms

Author: | Published: 5 Jan 2004
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How can Japan develop a disclosure system that will make its capital markets more credible to investors? Every country seeks an answer to this question, particularly after the accounting system crisis that occurred in America, evidenced by the Enron bankruptcy. Japan is no exception.

Recent disclosure reforms in Japan consist of two trends - increasing informative disclosure in public capital markets and enlarging private capital markets that do not require a disclosure obligation. It is necessary to require disclosure contents to be more substantive and credible for the general investors in the public capital markets, to facilitate participation. But there is a trade-off between more informative disclosure and lower cost finance.

In the private capital markets where participants are limited to mainly professional investors, an issuer's disclosure obligation is not necessarily required because professional investors are usually able to obtain useful investment information and make decisions at their own risk regardless. Therefore, it is also necessary to enlarge private capital markets to enable issuers to obtain low cost finance.

More informative disclosure in the public capital markets

The Japanese disclosure system has been criticized because the contents of both the initial and the continuing disclosure were too form-oriented and did not necessarily include substantive information. In addition, for continuing disclosure, only annual and semi-annual disclosures had been required; quarterly disclosures had not. Recent reforms have changed this.

Substantive disclosure
The changes to the corporate disclosure system require a company to additionally disclose in its securities registration statement and annual securities report the following three substantive items: business risk factors; management's discussion and analysis of the company's financial condition and operation results; and corporate governance conditions. The guidance notes for the recent disclosure forms provide examples of the above three items.

For business risk factors, a company is required to disclose: unusual changes in financial condition, operation results and cash flow; dependence on certain transaction parties, products and technologies; any unusual legal restriction, trade practice and management policy; significant litigation; significant items relating to directors, large shareholders or related companies; and any other item that could materially affect the judgment of investors.

For management's discussion and analysis of financial condition and operation results, a company is required to disclose its representative's view of the financial condition and operation results, including factors that could materially affect operation results, source of its capital, and fluidity of its funds.

For corporate governance conditions, a company is required to disclose: its organization; the arrangement of its internal regulatory system; the arrangement of its risk management system; its directors' remuneration divided between inside directors and outside directors; its certified public accountants' remuneration divided between the remuneration related to auditing based on audit contracts; and remuneration related to any service other than auditing.

Generally, the substantive requirements are applicable to the annual securities reports for the business year ending on or after March 31 2004 and to the securities registration statements filed on or after the date on which the annual securities reports satisfying such substantive requirements are filed. But any company may file its annual securities reports satisfying such substantive requirements on or after April 1 2003. As for the annual securities reports for the business year ending on March 31 2003, 17 companies have filed their annual securities reports satisfying the substantive requirements noted above.

In addition, a representative of the company's directors may voluntarily attach to its securities registration statement, annual securities report and semi-annual securities report, a paper in which the representative confirms the suitability of the statements made in such securities registration statement, annual securities report and semi-annual securities report. As for the annual securities reports for the business year ending on March 31 2003, 21 companies have filed their annual securities reports with such confirmation paper attached.

Quarterly disclosure
The Securities and Exchange Law of Japan does not generally require a company to report quarterly business results and its financial condition. Although certain listed companies voluntarily disclose financial results on a quarterly basis, only companies that have their securities listed on certain markets for emerging companies, such as Mothers on the Tokyo Stock Exchange (TSE), had been required to file quarterly disclosure statements under the regulations of the relevant stock exchanges.

Most capital markets around the world are increasingly recognizing that publicly listed companies should be required to report their business results and financial condition more frequently and in a clear uniform manner. This enables general investors to assess profitability and financial health more regularly. To compete with foreign markets, many of which require listed companies to disclose such information, each Japanese stock exchange, as well as the Japan Securities Dealers Association, requires companies listed on any Japanese stock market to file quarterly disclosure statements.

For example, the TSE requirements for domestic companies are divided into two stages. First, each listed company is required to file a management summary of business results on a quarterly basis from April 2003. The information contained in the management summary may only provide a general overview. Secondly, from April 2004, each listed company will be required to file quarterly financial statements that basically consist of a summary balance sheet and a summary profit and loss statement, in addition to a management summary. However, because preparation of financial statements is costly and requires preparation time, TSE recently announced that the requirement for filing quarterly financial statements would not actually come into effect until about three years after April 2004.

According to the TSE, 40% of listed companies, whose business year ends on March 31, voluntarily filed their first quarterly disclosure with their financial statements. If a quarterly disclosure system is set up through quarterly disclosure requirements being imposed by each stock exchange and by the Japan Securities Dealers Association, these requirements may soon be included in the Securities and Exchange Law.

Electronic filing
From June 1 2004, all issuers (including foreign companies) that are required to file certain statutory disclosure documents (including securities registration statements, annual and semi-annual securities reports and extraordinary reports) in Japan under the Securities and Exchange Law, will be required to file such documents electronically through the Electronic Disclosure for Investors' NETwork (EDINET), instead of using paper documents. Filing companies will no longer be permitted to file paper documents, unless an extraordinary event such as a power failure occurs.

EDINET is similar to the Edgar filing system operated by the US Securities and Exchange Commission. All electronic documents filed through EDINET may be accessed by anyone through the internet. Therefore, general investors will be able to easily obtain investment information.

Enlarging the private capital markets

Raising finance in the public capital markets enables an issuer to acquire a large volume of funds from general investors, but this costs the issuer a lot of money at the time of issue and on a continuous basis as long as the securities are outstanding. It is thus necessary to provide cost-effective financing measures other than finance in public capital markets.

If participants in the private capital markets are limited to professional investors, or the number of such participants is limited, the general investor's exposure to risks from investment in these markets can be reduced.

Before the recent disclosure reforms, both the concept of private capital markets and the participants in these markets were unnecessarily limited. This has changed.

Concept of private capital markets
The Securities and Exchange Law provides for two types of private placements in which an issuer is not required to file a securities registration statement as an initial offering disclosure obligation - private placement to a small number of investors, and private placement to qualified institutional investors.

Private placements to a small number of investors may solicit no more than 49 investors. Before the reforms, however, every solicitation to a qualified institutional investor was included in the calculation of the 49 investors. Now, solicitations to qualified institutional investors are not included in the calculation if the total number of qualified institutional investors is not more than 250 and certain transfer restriction requirements are satisfied.

Also, before the reforms, shares or other equity-linked securities could not be offered as securities for private placements to qualified institutional investors. Now, generally, if a class of shares is not publicly traded and certain transfer restriction requirements are satisfied, such class of shares or securities linked to such class of shares may be offered as securities in private placements to qualified institutional investors.

Increasing the number of participants
Issuers are now able to offer securities in Japan by way of private placement to any number of foreign investors who meet the criteria of qualified institutional investors under the Securities and Exchange Law of Japan.

Before the disclosure reforms, issuers had few means available to offer their securities in Japan to foreign entities by way of private placement. Since qualified institutional investors did not include foreign investors, issuers were limited to offering their securities in Japan to no more than 49 foreign investors. The definition of qualified institutional investor has been amended to include foreign investors.

To be a qualified institutional investor, a foreign investor must satisfy two requirements. First, it must be one of the following: (a) a foreign securities firm, investment asset management firm, bank, insurance company, or discretionary investment manager set up in accordance with foreign laws that meet certain capitalization requirements based on type of business; (b) a foreign government, government authority, municipal government, central bank, or international institution to which Japan has acceded; or (c)a foreign company that files securities reports in Japan and that meets certain asset requirements.

Secondly, a foreign investor must register with the Financial Services Agency in July each year. Registration is effective for one year from September 1 of that year to August 31 of the next year.

Foreign qualified institutional investors must also appoint a Japanese resident as an agent, which represents the investor in making necessary registration filings and receiving notices and documents pertaining to the securities it holds, which have been acquired by means of a private placement in Japan.

For Japanese investors, the recent disclosure reforms have permitted certain venture capital companies and venture capital limited partnerships that are set up or formed in Japan, to be included as qualified institutional investors.

More reform

Disclosure reforms in Japan are expected to continue. The government is considering improving disclosure contents to make them more user-friendly for general investors and allowing disclosure in English rather than in Japanese. Whether this will be allowed will be determined by considering the general investors' benefits as well as the convenience and the cost.

If it were permitted, a foreign issuer planning to issue securities in the global capital markets, including in Japan, could provide the disclosure more cost effectively, and the Japanese markets could compete more easily with foreign markets where disclosures are made in English.

Author biography

Hiroyuki Ishizuka

Nagashima Ohno & Tsunematsu

Hiroyuki Ishizuka is a partner at Nagashima Ohno & Tsunematsu. His practice focuses on securities transactions such as cross-border equity and debt offerings - including US registered offerings of shares of Japanese corporations and public offerings of Samurai bonds in the Japanese market - and mergers and acquisitions involving Japanese listed corporations.

He graduated in 1989 with an LLB from Chuo University, Department of Law and in 1997 with an LLM from Columbia University School of Law. He was admitted to practice law in Japan (1993) and in New York (1998). He worked at Schulte Roth & Zabel in New York as a foreign associate from 1998 to 1999.

Yutaka Kitamura

Nagashima Ohno & Tsunematsu

Yutaka Kitamura is an associate at Nagashima Ohno & Tsunematsu. His main area of practice is capital market and securitization transactions, and financial taxation. He was admitted to the bar in Japan in 2000. He graduated with an LLB (1998) and with an LLM (1999) from the University of Tokyo.

He has authored: Law and Regulation of Financial and Capital Markets Vol 1 - Disclosure Issues of Global Offerings - Quarterly Disclosure Issues, Jurist 1222 (May 2002) (co-author); The struggles in meeting the new convertible bonds requirements, IFLR Guide to Japan (January 2003) (co-author); and Analysis of Tax Cases regarding International Transactions Vol 6 - Banks' Use of Creditable Amount of Foreign Taxes, Journal of the Japanese Institute of International Business Law Vol 31, 6 (June 2003). He has also drafted international legal articles for IFLR (from February 2002) with respect to new developments in Japanese law.

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