The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Financial Instruments and Exchange Law of Japan - a closer look

Kenji Kawahigashi

Clifford Chance

Q3 2007



The implementation of the Financial Instruments and Exchange Law (FIEL) is fast approaching. The new law must come into effect by 13 December 2007. However, it is understood that the law may come into effect as early as the third quarter this year. Accordingly, it is an appropriate time to take a closer look at some of the provisions of FIEL. In particular, some of the changes it will bring to the registration requirements for regulated businesses.

Registration Requirements

It is now commonly understood that FIEL will introduce four main categories of registration which will apply to different types of "financial instruments trading business", namely:

1. First financial instruments trading business (Type I FIT) registration, which will generally apply to broker-dealers concerning traditional types of securities, such as shares, bonds and investment trust units, and also to underwriting businesses:
2. Second financial instruments trading business (Type II FIT) registration, which will generally apply to broker-dealers concerning "deemed securities" and also to issuers of certain types of collective investment scheme interests:
3. Investment advisory and agency (IA) registration, which will apply to entities that provide securities investment advice (but not discretionary investment services) and entities that act as an agent or intermediary with respect to entering into investment advisory or discretionary investment management contracts, and:
4. Investment management (IM) registration, which will apply to entities that provide discretionary investment management services, such as portfolio-management services.

In order to better understand the scope of these requirements and how they may differ from the current position under the Securities and Exchange Law (SEL), it is useful to consider the registration requirements that will apply under FIEL to some common types of Japanese investment structures.

TK Structures

A TK or tokumei kumiai is a type of two party agreement governed by the Commercial Code of Japan. The agreement is between (i) an entity termed the "eigyo-sha" (the TK Operator), which carries out a particular business, such as investment in securitised real properties assets in Japan, and (ii) an investor in the business (the TK Investor). Usually, the day-to-day management of the TK Operator's investments will be managed by another company (the Asset Manager) pursuant to an investment management agreement.

Each of the entities involved in the operation of the TK may be subject to different registration requirements under FIEL, for example:

(a) TK Operator
The TK Operator will generally make a private offering of TK interests to the TK Investor. Under the SEL, an issuer of securities currently does not require any license for its own securities offering. However, under FIEL, an issuer of certain types of collective investment scheme interests (including TK interests) will be required to obtain Type II FIT registration for the offering or solicitation of the interests.

In addition, the TK Operator will manage capital received from the TK Investor. Under the SEL, the TK Operator currently does not require any registration for the securities portfolio management of funds received from the TK Investor. However, FIEL requires companies that manage capital in this way to obtain IM registration. The TK Operator will further, however, be exempt from this IM registration requirement if a third party Asset Manager is retained by the TK Operator and the management of capital is actually being carried out by such Asset Manager which is duly registered as IM.

It is possible that a TK Operator will be able to avoid the requirement to obtain Type II FIT and IM registration by relying upon an exemption provided under FIEL. In short, FIEL provides that if all of the TK Investors consist of "qualified institutional investors, etc" then the TK Operator is not required to obtain IM or Type II FIT registration.
Finally, in the case of real estate funds, it is common to use a trust structure together with the TK structure, whereby the TK Operator buys and sells trust beneficial interests (TBIs) rather than the real estate itself. Under FIEL, TBIs will fall within the definition of "securities" such that entities that buy and sell TBIs will be required to obtain Type II FIT registration. As the TK Operator would technically buy and sell TBIs, this is another reason why the TK Operator may be required to obtain Type II FIT registration.

(b) Asset Manager

FIEL requires entities that provide securities investment advice to obtain IA registration; as the Asset Manager will generally provide the TK Operator with securities investment advice (including advice in relation to the sale and purchase of TBIs), it would require IA registration.

If the Asset Manager provides portfolio-management services to the TK Operator (i.e. if it is granted discretionary power to sell and purchase securities on behalf of the TK Operator), it would be required to obtain IM registration under FIEL.
It is possible that the Asset Manager may also sometimes provide assistance to the TK Operator (or its contract counter-parties) in connection with the sale and/or purchase of securities (such as TBIs). Under FIEL, an entity that provides this kind of service (namely acting as an "intermediary" with respect to sale and purchase of securities) is required to obtain Type I and/or Type II FIT registration.
Finally, it is also possible that the Asset Manager would assist with the offering of securities, in particular the issue of TK interests by the TK Operator to the TK Investor. Once again, this type of activity requires Type II FIT registration.


TMK Structures

A TMK is one type of legal entity used for asset liquidation created under the Japanese Asset Liquidation Law (or TMK Law). The TMK Law was enacted for the purpose of enabling the liquidation or securitisation of specific existing assets. However, TMK structures are also sometimes used for the acquisition of real estate due to certain tax benefits that accompany the structure.

The registration requirements applying to a TMK structure are different to those applying to a TK structure. Unlike a TK Operator, a TMK will not be required to obtain Type II FIT registration in order to market and issue its own common or preferred shares. However, if the TMK engages a third party to market its shares then that third party will require Type I FIT registration.

In addition, unlike a TK Operator, a TMK will not require IM registration in order to manage the capital received from investors. However, a TMK is not permitted to manage its own assets. The management of the TMK's assets must be sub-contracted to a third party Asset Manager. Since the Asset Manager will provide discretionary investment management services, the Asset Manager will need to obtain IM registration. As noted above, the Asset Manager may also require Type I and/or Type II FIT registration if it is involved in the sale and purchase or offering of securities.

Foreign Funds

In addition to the domestic registration requirements mentioned above, FIEL will also change some of the requirements for foreign funds wishing to enter the Japanese market. In the past it has been common for foreign funds to enter the Japanese market by establishing a branch office, rather than creating a subsidiary in Japan. However, FIEL will impose two additional burdens on the use of a branch office in regard to Type I FIT registration and IM registration:

1. The foreign entity that is forming the branch office in Japan (which applies for the registration) should be similar to a Japanese kabushiki kaisha (K.K.) with a board of directors. As a result, an LLC will generally not be eligible for such purposes.
2. The foreign entity must also possess relevant authorisations from the regulatory authorities in its own jurisdiction concerning its financial instruments trading business.

It should be noted that the above requirements will only apply to branch offices seeking Type I FIT and IM registration, not Type II FIT and IA registration.

Nevertheless, these new requirements may contribute to an increase in the use by foreign funds of subsidiaries in Japan rather than branch offices.

Closing Comments

The implementation of FIEL will create new registration requirements for regulated businesses. It is clear that the scope of those registration requirements will depend upon the particular investment structure used. FIEL will also see the introduction of new requirements for foreign funds looking to enter the Japanese market.

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