A regulatory revolution

Author: | Published: 1 Apr 2007
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A comprehensive amendment to the Securities and Exchange Law (SEL) of Japan was introduced in June 2006 and is expected to become substantially effective mid-2007 (or at the latest by December 2007). In connection with the amendment the SEL will be renamed the Financial Instruments and Exchange Law (FIEL).

Aims of the amendment include: (i) establishing a cross-sectional and flexible regulatory framework covering a wide range of financial instruments and services; (ii) enhancing disclosure requirements; (iii) strengthening criminal penalties against market fraud; and (iv) ensuring appropriate management of self-regulatory organizations. Financial fraud cases employing new financial products were not covered by the SEL, so significant emphasis is being placed on broadening the coverage of the regulation and expanding supervision over firms dealing with financial products. In the process of drafting the bill, government officers took into consideration laws and experiences in other jurisdictions, such as EU Directive 2004/39/EC on Markets in Financial Instruments, the UK Financial Services and Markets Act 2000, and the US Investment Company Act of 1940 and Sarbanes-Oxley Act of 2002.

Collective investment schemes

Paragraph 1 of Article 2 of the FIEL provides a list of securities, all of which are premised on issuance of certificates or instruments representing securities. Paragraph 2 provides a list of rights and interests that are not in the form of certificates or instruments and are accordingly illiquid, but which are deemed securities for the purpose of ensuring public interest and investor protection.

Among various collective investment schemes (CISs), beneficial interest certificates of investment trusts and investment securities of investment corporations are classified as traditional securities under Paragraph 1, while beneficial interests in trust that do not assume issuance of certificates or instruments are categorized as deemed securities under Paragraph 2. As in other jurisdictions, private equity or venture capital funds in Japan usually take a form of partnership, the interests of which fall within the definition of deemed securities under Article 2(2), Item 5 of the FIEL. Item 5 is considered a catchall definition of CISs and principally comprises partnership-type funds (see box). The definition employs the cash contribution element and the passiveness element used in the Howey test under US law and in the definition of CIS under the UK Financial Services and Markets Act. Item 6 provides for deemed securities that are rights or interests under foreign laws similar to those provided in Item 5. Accordingly, private equity or venture capital partnerships will be regulated as deemed securities or Paragraph 2 securities, regardless of whether they are established in Japan or overseas.

Catchall definition of CISs under Article 2(2), Item 5 of the FIEL

"Rights under a general partnership (nin-i kumiai) agreement, a silent partnership (tokumei kumiai) agreement, an investment business limited partnership agreement or a limited liability partnership business agreement, membership rights of an incorporated association, and other rights, which are entitled to receipt of dividends from revenues arising from or of distributions of properties concerning business using cash (or certain equivalents prescribed by the Cabinet Order) contributed or donated by holders of those rights, but which do not fall within any of the following sub-items: (a) rights of holders in a case where, as prescribed by the Cabinet Order, all holders are engaged in the business; (b) rights of holders which do not entitle them to receipt of dividends from revenues or of distributions of properties concerning the business in excess of the amount of their contributions or donations; (c) rights under an insurance agreement, a certain mutual aid agreement or a real estate specific joint enterprise agreement; or (d) other rights prescribed by the Cabinet Order as not detrimental to public interest or protection of holders even where those rights are not deemed as securities."

Disclosure of partnership interests

An offering or placement of newly issued securities in Japan is, in general, subject to a registration requirement under the SEL or the new FIEL unless it satisfies either set of requirements for the two traditional private placement exemptions. One is the small number private placement exemption, whereby the number of investors solicited (excluding qualified institutional investors (QIIs) if certain conditions are met) must be 49 or less, with a restriction on re-sales other than to a single investor at a time. The other is the QII private placement exemption, whereby investors solicited can be QIIs only, with a restriction on re-sales other than to another QII.

As the FIEL comes into force, a new private placement exemption will be created for Paragraph 2 securities, including partnership interests. Under Article 2(3), Item 3 of the FIEL, a placement of partnership interests is exempted from the registration requirement unless it constitutes a case where, as prescribed by the Cabinet Order, a substantial number of investors are to own interests. Although details of the amendment of the Cabinet Order are not available yet, the substantial number is expected to be 500. The limit of the private placement exemption for partnership interests will be relaxed from 49 offerees to 499 purchasers. When making use of a private placement exemption, a person soliciting investors must comply with the notice requirement under Article 23-13 of the FIEL whereby they are required to deliver to an investor a written notice prescribed by the related Ministerial Ordinance.

As well as the creation of the new private placement exemption, however, certain types including partnership interests and other of Paragraph 2 securities, are designated under Article 3 of the FIEL as exempt from the registration requirement and other disclosure regulations. Exempted are Paragraph 2 securities other than: (a) Paragraph 2 securities provided in Article 2(2), Item 5 of the FIEL if, as prescribed by the Cabinet Order, the business of a CIS is principally investment in securities; (b) other Paragraph 2 securities prescribed by the Cabinet Order as similar to (a); and (c) Paragraph 2 securities otherwise prescribed by the Cabinet Order. The term principally will be construed to indicate a case where more than 50% of assets of a CIS are to be invested in securities.

Private equity or venture capital partnerships usually invest more than 50% of their assets in securities. Accordingly, they are not exempt from the disclosure regulations and need to use the newly created private placement exemption to avoid the registration requirement. In contrast, interests in partnerships whose business is not principally investment in securities are exempt from the disclosure regulation under the FIEL. Aside from the disclosure regulation, the broker/dealer regulation aspect of the FIEL requires registered firms engaged in the financial instruments business to comply with the information provision requirement.

Firms in financial instruments business

Article 2(8) of the FIEL provides the definition of financial instruments business, most of which was defined as the securities business under the SEL. Financial instruments businesses are, in general, subject to the registration requirement under Article 29 of the FIEL and are classified under Article 28 into four business categories:

  • Type 1 financial instruments business, including the business of the sale and purchase, brokerage, and handling of a public offering, a private placement or a secondary public offering with respect to Paragraph 1 securities, and the underwriting business.
  • Type 2 financial instruments business, including the business of conducting a public offering or a private placement of Paragraph 2 securities provided in Article 2(2), Items 5 and 6 of the FIEL (for example, partnership-type CIS interests) and the business of the sale and purchase, brokerage, and handling of a public offering, a private placement or a secondary public offering with respect to Paragraph 2 securities.
  • Investment advisory and agency business.
  • Investment management business, including the discretionary investment business and the business of managing cash contributed or donated by holders of rights in CISs and other assets by investing principally in securities and/or derivative transactions on the basis of an investment decision based on analysis of value of financial products, amount of option premiums or trends of financial indices.

A general partner conducting a public offering or a private placement of partnership interests, who is treated as issuers of securities, were not subject to the securities business regulation under the SEL but will become regulated as type 2 financial instruments business under the new FIEL. Sale and solicitation activities concerning partnership interests, being Paragraph 2 securities, by any person other than a general partner are also regulated as type 2 financial instruments business. A general partner's management of a partnership constitutes investment management business. As a result, a general partner of a private equity or venture capital partnership is required to be registered as a financial instruments firm engaged in the type 2 financial instruments business and in the investment management business. However, certain business activities of a general partner are exempt from the registration requirement of financial instruments firms under special rules concerning exempted business for QII-targeted funds discribed below.

Business conduct regulation

Regulation of financial instruments firms comprises entry regulation (that is, the registration requirement), principal shareholder regulation, regulation of other businesses engaged in by financial instruments firms, business conduct regulation, accounting regulation and government supervision regulation.

The business conduct regulation of registered financial instruments firms includes certain information provision requirements, which supplement the disclosure regulation, especially in the context of selling and soliciting Paragraph 2 securities. Registered firms are required under Article 37-3 of the FIEL to deliver their customers an explanatory document, outlining the financial instruments contract, consideration payable by customers, certain market risks and credit risks, and other matters prescribed by the related Ministerial Ordinance, in advance of entering into the contract. If a registered firm conducts or deals with a public offering or a secondary public offering of Paragraph 2 securities, the firm is, in principle, required to provide prior notification to the government concerning the substance of an explanatory document. Registered firms are also subject to the document delivery requirement under Article 37-4 of the FIEL without delay after entering into a financial instruments contract with a customer.

A periodic information provision requirement is placed on registered financial instruments firms engaged in the investment management business. These firms are, in general, required to periodically prepare and deliver to known holders of rights a management report under Article 42-7 of the FIEL. Firms engaged in managing a partnership principally investing in securities and/or derivative transactions are generally required to notify the government without delay after preparation of a management report, with certain exceptions.

As part of the business conduct regulation, registered firms are obligated under Article 36 of the FIEL to conduct their business activities honestly and fairly toward their customers, while registered firms engaged in the investment management business also owe a duty of loyalty as well as a duty of care of good managers to their customers under Article 42. As well as the prohibited transactions provided in Article 38 of the FIEL that generally apply to registered firms, registered firms engaged in the investment management business are subject to the prohibition on conflict of interest transactions provided by Article 42-2. Violation of the business conduct regulation could result not only in an administrative action but also in a criminal fine against a registered firm.

To establish a flexible regulatory scheme corresponding to the attributes of investors, a special rule concerning professional investors under Article 45 of the FIEL relieves a registered firm of certain general business conduct regulations, such as the information provision requirements and the suitability doctrine, when dealing with professional investors. Professional investors are defined under Article 2(31) of the FIEL as QIIs, the national government, the Bank of Japan and such corporations as prescribed by the related Ministerial Ordinance. These corporations may opt in the investor protection provided by the general business conduct regulations by electing to be treated as non-professional investors. A certain category of non-professional investors may elect to be treated as professional investors and have an opportunity to participate in financial products or transactions aimed only at professional investors.

Exempted business for QII-targeted funds

In consideration of CISs' role in directing financial assets of the investing public to provide risk capital in the business industry, an exception to the registration requirement of financial instruments firms is provided in the FIEL in connection with funds targeting QIIs. Under Article 63 of the FIEL, conducting a private placement of interests in, or managing, a QII-targeted partnership is not subject to the registration requirement, and only to the prior notification requirement, if certain conditions are met.

One or more limited partners of a QII-targeted partnership must be QIIs. The partnership may include a certain number of non-QII limited partners. The maximum number of non-QIIs is expected to be around 49. Limited partners of QII-targeted funds cannot be: (a) a special purpose corporation whose asset-related securities are acquired by a non-QII; (b) an operator of a silent partnership (tokumei kumiai), any silent partner of which is a non-QII; or (c) other persons prescribed by the related Ministerial Ordinance as similar to (a) or (b). A general partner intending to make use of a special rule concerning the exempted business for QII-targeted funds would not be able to solicit another CIS having a non-QII as a limited partner.

A firm engaged in the exempted business for QII-targeted funds is not subject to any business conduct regulation except that it is prohibited from compensating losses incurred by investors and from making false statements to investors.

Regulation of foreign firms

Foreign firms engaged in financial instruments business are, in general, subject to the same regulatory regime described above. Accordingly, they must be registered under Article 29 of the FIEL unless they are engaged only in the exempted business for QII-targeted funds under Article 63, which requires a prior notification to the government in place of registration. However, certain exceptions are available for foreign securities firms and for foreign firms engaged in the investment advisory business or the investment management business.

Special rule for foreign securities firms

Article 58 of the FIEL defines foreign securities firms as persons engaged in securities related business in foreign jurisdictions in accordance with foreign laws. Securities related business, defined by Article 28(8) of the FIEL and traditionally known as securities business under the SEL, includes underwriting and handling of public offerings, secondary public offerings or private placements of securities. Although foreign securities firms are, in general, prohibited from engaging in any activities of securities related business with a person in Japan, they are permitted under Article 58-2 of the FIEL to engage in these activities if the counterparty is a registered financial instruments firm engaged in the securities related business or in any other case prescribed by the Cabinet Order.

Although no amendment to the Cabinet Order in this regard was yet been published under the FIEL, the current Cabinet Order for Enforcement of the Law on Foreign Securities Firms, which will soon be superseded by the FIEL, provides that a foreign securities firm that does not have a presence in Japan may, without being registered in Japan, engage in securities transactions with the Bank of Japan and certain government entities and financial institutions in Japan. It may also carry out certain transactions upon instruction from a person in Japan, provided that there has been no solicitation of such persons in Japan regarding a securities transaction. It is expected that a similar provision will be prescribed in the Cabinet Order under the FIEL.

Foreign securities firms are permitted, with a licence from the government, to participate in underwriting agreements entered into with issuers of securities and to engage in other activities prescribed by the Cabinet Order in Japan, or to engage in the business of sale and purchase of securities on the exchange market and of market derivative transactions.

Foreign firms in investment advisory or investment management business

Foreign firms engaged in the investment advisory business, the discretionary investment business, or the business of managing a partnership-type CIS in foreign jurisdictions are permitted under Article 61 of the FIEL to engage in their respective business if counterparties of the business are limited only to registered financial instruments firms engaged in the investment management business and to such other persons as may be prescribed by the Cabinet Order.

Transitional measures

Certain provisions concerning the regulatory treatment of partnerships will already exist at the time the FIEL becomes effective. Existing partnerships that would meet the requirements for exempted business for QII-targeted funds will have three months to make a notification from the effective date of the FIEL for the purpose of the investment management business (as opposed to a general rule that a notification must be made before engaging in the relevant business). For persons actually engaged in the investment management business as of the effective date of the FIEL, no registration will be required as long as the solicitation of interests in respect of the partnership started before the effective date, and only notification is required. However, the application of these transitional measures does not provide a full release from the regulations under the new FIEL. Also, those who continue to engage in the investment management business by making such transitional notification are prohibited from compensating losses incurred by investors and from making false statements to investors.

Author biographies

Satoshi Nakamura

Mori Hamada & Matsumoto

Satoshi Nakamura is a partner of Mori Hamada & Matsumoto. He was admitted to the Japanese Bar in 1991 and to the New York Bar in 1999. He is a graduate of the University of Tokyo (LLB, 1989) and Columbia Law School (Harlan Fiske Stone Scholar, LLM, 1995). He practises primarily in the areas of corporate/securities, including capital markets, private equity/venture capital, and mergers and acquisitions. He has served as a visiting lecturer on securities and exchange law at Nagoya University Law School since 2005. He is a member of the Capital Markets Forum Working Group in Japan and the Association for Securities and Exchange Law Studies.

Mitsue Tanaka

Mori Hamada & Matsumoto

Mitsue Tanaka is an attorney with Mori Hamada & Matsumoto. She was admitted to the Bar in Japan in 2000 and in New York in 2006. She was educated at the University of Tokyo (LLB, 1998) and Columbia Law School (LLM, 2005), and worked with Morgan Lewis & Bockius in New York from 2005 to 2006. She specializes in the areas of private equity financing, corporate finance, securitization and other structured finance. She is the co-author of "Banks see the benefits of syndicating risk" IFLR, May 2004.