Securities compliance

Author: | Published: 5 Jan 2004
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Securities firms play an important role as intermediaries between investors and the securities market. In this respect, it is particularly important for securities companies to comply with the law. Loss of faith in securities companies as intermediaries would jeopardize the proper functioning of the securities market itself.

The laws pertaining to securities firms are both complicated and numerous (more than 40 such laws are mentioned in the Financial Services Agency's (FSA's) Inspection Manual for Securities Companies). Therefore, it is a challenge for securities firms to create and implement an effective internal control system.

Regulation of securities firms' business

During the past three years, many securities companies, primarily foreign ones, have been subject to administrative disposition by the FSA for illegally undertaking activities that are not permitted without filing notification with, or obtaining approval from, the director of the relevant local finance bureau as specified in section 34 of the Securities and Exchange Act (Securities Act). These activities include: brokerage of Tokumei Kumiai (silent partnership) agreements; brokerage of deposits; brokerage of joint and several suretyship agreements; credit derivative transactions; brokerage of sales of loan receivables; brokerage of swap agreements; brokerage of loans; and provision of advice on the management of businesses.

Because securities firms were involved in these activities without filing notification or obtaining permission, they were found to be in violation of section 34 of the Securities Act.

The business activities that securities companies are permitted to undertake under the Securities Act are as follows:

Securities business activities (Securities Act, section 2, paragraph 8)
The primary business activies such as dealing, brokerage, and underwriting of securities.

Incidental business activies (Securities Act, section 34, paragraph 1)
Those activities incidental to the above securities business activities that securities firms are permitted to undertake without notification or approval.

Business activities permitted with notification (Securities Act, section 34, paragraph 2)
Such business activities include investment advisory and investment trust management, which are enumerated in section 34, paragraph 2 of the Securities Act. Securities firms can be engaged in such business on notifying the finance bureau director because such business activities can be undertaken without negatively affecting the overall business of securities firms generally. Section 34, paragraph 3 requires notification to be made without delay when securities firms come to carry out any of the business activities identified in paragraph 2, which implies that notification may be made post-fact. But the FSA has announced its interpretation that such notification must be made before undertaking such activity.

Business activities requiring approval (Securities Act, section 34, paragraph 4)
Securities firms can undertake business activities that do not fall under any of the above categories, provided that they have obtained approval from the finance bureau director. The time period for obtaining such approval is generally one month.

Before the 1998 amendments to the Securities Act, securities firms were prohibited from engaging in other business activities. Only those businesses involved in securities and securities-related business activities (which do not affect the securities business of the company from the viewpoint of public interest and the protection of investors) were allowed with the approval of the then Ministry of Finance. This system was abolished with the 1998 amendments and a list of example ancillary business activities was codified. Other business activities not included on the list may be possible, subject to relevant notification or approval.

As mentioned, the business activities that require notification to the finance bureau director are specified in section 34, paragraph 2 of the Securities Act. Other business activities require the approval of the finance bureau director, rather than simple notification. Securities firms are under the close supervision of the relevant authorities by requiring such companies to obtain approval for any business activities other than those clearly permitted by the Act and relevant regulations.

For example, if a securities firm wishes to undertake a credit derivatives transaction, it must obtain the approval of the finance bureau director. By comparison, for a bank, credit derivatives transactions are ancillary business activities as identified under section 10, paragraph 2 of the Banking Act. No special procedure is required for a bank to undertake such transaction.

Similarly, securities firms need to obtain approval to undertake the sale and purchase of trust beneficial interests in monetary claims. In this regard, a list of the business activities permitted with notification include "sales or brokerage of monetary claims" (section 25, paragraph 7 of the Cabinet Order Concerning Securities Companies (Securities Companies Order)), which is not regarded as inclusive of trust beneficial interests in monetary claims. Because this list is restrictive, approval is necessary for such business activities.

For banks, the sale and purchase of trust beneficial interests in monetary claims is likely to be interpreted as ancillary to the banking business. Although the list of such ancillary businesses (appearing in section 10, paragraph 2 of the Banking Act) does not specify the sale and purchase of trust beneficial interests, this list does provide examples of ancillary business activities, and the sale and purchase of trust beneficial interest in monetary claims would probably be considered an ancillary business activity.

Specific details on the activities of securities firms that were subject to administrative disposition are not publicized. When securities firms are inspected by the FSA, there have been cases where the inspectors pointed out that the activities conducted as part of a securitization transaction were in violation of the laws and regulations because of a failure to file or obtain the required notification or approval.

In practice, when a securities firm, as arranger, gives advice to an originator regarding the structuring of a securitization transaction, this is done as "consulting services (soudan) for the management of other business entities" (section 34, paragraph 2-10 of the Securities Act, section 25, paragraph 12 of the Securities Companies Order). Notification in accordance with section 34, paragraph 3 of the Securities Act is all that is required for securities firms to give such management consulting.

But this can become complicated depending on the structure of the particular securitization. For example, if a Tokumei Kumiai (TK) agreement is involved as part of the structure of the securitization transaction, the securities firm is regarded as an intermediary for the execution of the TK agreement and must file a separate notification in addition to the notification concerning the management consulting (section 25, paragraph 6 of the Securities Companies Order).

Similarly, if the structure of the securitization involves a joint and several suretyship agreement, it is not clear that the management-consulting category would cover the brokerage of a joint and several suretyship agreement by a securities firm as arranger. This is because the word brokerage (baikai) is considered to include the activities of an intermediary of a commercial transaction, and is not thought of as falling within the meaning of consulting services.

Joint and several suretyship agreements are used regularly in securitization transactions as a way to provide credit enhancement. In such cases, it is common for an arranger to provide the service of finding a guarantor company, and of negotiating between the guarantor and the creditor so that a joint and several suretyship agreement is entered into. This activity would generally be regarded as brokering, as opposed to management consulting. Thus, the arranger must obtain the approval of the finance bureau director under section 34, paragraph 4 of the Securities Act with respect to such activity as intermediary of a suretyship agreement, and must also give notification with regard to the provision of management consulting.

Firewall regulations

One of the activities for which securities firms have recently become subject to administrative disposition by the FSA is violation of the firewall regulations.

These regulations were created to eliminate conflicts of interest between securities firms, which are expected to act as intermediaries in the securities market to carry on transactions in a fair and just manner, and their affiliates. It is not uncommon for a securities firm and its affiliate to be involved in the same securitization transaction, where conflict of interest arises. The regulations are stipulated in section 45 of the Securities Act as well as section 12 of the Cabinet Order Concerning Regulation of the Conduct of Securities Companies (Regulations Order).

Such regulations include the prohibition on giving or receiving undisclosed information. Section 12, paragraph 7 of the Regulations Order prohibits: "A securities company, its directors, auditors or employees to obtain from, or furnish to, a parent or subsidiary of the securities company undisclosed information of an issuing company or a customer."

Undisclosed information is defined as: (i) undisclosed, material information with respect to the management, operation or assets of the issuing company, which is deemed to exert influence over the investment judgment of a customer; or (ii) information on the trend of orders for the sale or purchase of a security placed by customers or any other special information obtained by a director or auditor or employee of the securities company or a parent or subsidiary thereof, which came to their knowledge in the line of business. But this does not apply in the case that the prior written consent of such issuers or customers is obtained with respect to the furnishing of such non-disclosed information. For this reason, prior written consent (not necessarily specific) is often obtained from issuers or customers.

Additionally, the prohibition on giving or receiving non-disclosed information is a regulation based on the Act Concerning Prohibition of Private Monopoly and Maintenance of Fair Trade (Antimonopoly Act). The Guidelines Concerning Unfair Trade Practices Resulting from Mutual Participation of Banks and Securities Companies issued by the Fair Trade Commission (FTC) provide that: "It may be in violation of the Antimonopoly Act if a subsidiary receives information from a parent company which is not generally disclosed, and by providing such information to its potential clients, solicits them to be engaged with such subsidiary."

Whether such action would constitute a violation of the Antimonopoly Act would depend on whether the content of such information and the means to provide such information is appropriate according to normal business practices. It does not appear to be considered a violation of the Antimonopoly Act if prior written consent has been obtained from the person who provides such information to the parent company.

In addition, the Act Concerning Protection of Private Information (Privacy Act) was recently enacted and it is expected that the provisions on the duty of private entities will take effect in April 2005. This Act provides the basic regulatory framework for the protection of personal information, based on which specific regulations applicable to financial institutions are expected to be enacted. Under this Act, extensive obligations are placed on private individuals and firms to protect the confidential information they collect from their customers. For example, the Act prohibits the provision of certain private information to others, with certain exceptions. Securities firms should watch how the Privacy Act and relevant regulations will be applied and enforced in practice.

While the Privacy Act aims to protect customers' interest in their private information, the regulations under the Securities Act and the Antimonopoly Act aim to ensure fair competition in the capital market as well. On the other hand, the purpose of forming a group consisting of various financial institutions is generally to provide an overall financial service to customers. To ensure efficient and suitable business activities, sharing information with affiliates would be necessary.

There is always strong incentive to share information within a group of companies, and therefore there is a high risk that a violation of the firewall and privacy regulations would occur. Thus, it is imperative that directors, statutory auditors and employees of securities companies be aware of such regulations.

Measures to ensure compliance in securitization

Securities firms themselves use various kinds of internal control systems. These include: (i) preparing compliance manuals to be provided to all employees; (ii) having in-house legal staff and internal control staff (such as compliance officers) responsible for monitoring and ensuring that corporate activities are always in compliance with relevant laws; (iii) providing regular training with respect to compliance issues; (iv) setting up a compliance committee; and (v) creating an internal whistle-blowing system (for example, a hot line with outside legal advisers).

Even with such systems in place, the complexity of the laws and regulations applicable to securitization transactions, and the increasing complexity and sophistication of such transactions, makes it difficult for securities firms to identify and resolve all compliance issues. Furthermore, securities firms are frequently engaged as arranger as well as underwriter.

The role of securities firms as arranger necessitates their involvement in all aspects of securitization transactions. Consequently, securities firms must verify their compliance with various laws and regulations relating to every aspect of the transaction. Such a burden would make it even more difficult for securities firms to do so in a thorough and comprehensive manner.

From experience, it does not appear that compliance issues are thoroughly reviewed in many securitization transactions. In general, focus is placed on reviewing the legal documents used (such as various agreements) with little attention paid to compliance issues.

Not infrequently, the person in charge of the securitization transaction at the securities firm does not know whether the proper notifications have been made and the requisite approvals have been obtained. There is very little excuse for not identifying all of the business activities of a transaction that require filing notification with or approval from the finance bureau directors.

Considering the complexity of securitization transactions and compliance issues, greater and more direct involvement by compliance staff or departments is required. It is also important to have direct communication between compliance staff and external counsel to identify and resolve compliance issues efficiently and effectively.

Author biography

Akihito Katayama

Atsumi & Partners

Akihito Katayama is a partner with the Tokyo law firm Atsumi & Partners. A graduate of The University of Tokyo (LLB, 1985), Katayama's career spans more than 15 years of legal practice in Japan, including three years as a judge and more than three years as a statutory auditor. Katayama earned an LLM from Harvard Law School in 1997 and then stayed for two years as a visiting scholar in East Asian Legal Studies. He is also admitted to the New York Bar. After 12 years with law firm Ushijima & Partners, five of those as a partner, Katayama joined Atsumi & Partners as a partner in 2003. His practice is focused on general corporate law, including domestic and international litigation, arbitration, M&A, real estate securitization, corporate governance and compliance. Katayama speaks Japanese and English.


Yuri Suzuki

Atsumi & Partners

Yuri Suzuki is an associate at the Tokyo law firm Atsumi & Partners. She graduated from the University of the Sacred Heart (Dept Foreign Languages, 1991), and after several years handling securities transactions for the international investment department of The Tokio Marine and Fire Insurance Co Ltd, she earned an LLB from Waseda University in 1997, and was admitted in 2001 (Daini Tokyo Bar) after successfully completing her training with the Legal Training and Research Institute of the Supreme Court of Japan. Since joining Atsumi & Partners soon after, Suzuki has made a name for herself as a dedicated lawyer in the areas of banking, securitization (including asset-backed securitization), structured finance and securities for Atsumi & Partners. She speaks Japanese and English.



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