AIMA

The Alternative Investment Management Association

Alternative Investment Management Association Representing the global hedge fund industry

Financial Instruments and Exchange Law of Japan

Kenji Kawahigashi

Clifford Chance

Q4 2006

 

Introduction
 

In June 2006, the Financial Instruments and Exchange Law of Japan ("FIEL") submitted by the Financial Services Agency ("FSA") to the Japanese legislature, the Diet, was enacted, and will take effect during 2007.

FIEL represents a significant change to the financial regulatory regime in Japan, unifying existing concepts to provide a more comprehensive and uniform regulatory regime for financial products and services generally, as well as expanding the regime to cover new products and activities, such as derivatives.

Along with the introduction of FIEL (which is technically an amendment of the Securities and Exchange Law ("SEL") both in title and content), various other statutes will be amended to bring them to a more uniform standard of regulation for financial products generally, or abolished and regulation of these areas will be absorbed into FIEL.


Broader coverage
 

FIEL will regulate a broader spectrum of financial products and services than current under SEL.

SEL was designed to focus on the regulation of "securities" - which includes debt securities, equity securities, interests in investment trusts and derivatives on securities.

FIEL will expand these concepts to cover "financial instruments" - which includes the existing concept of "securities" as well as trust beneficiary interests, interests in collective investment schemes and certain non-securities derivatives. This is a significant expansion of the regulatory regime - for example, credit derivatives and fixed income derivatives will now be classified as "financial instruments" and traders in these derivatives may require registration under the FIEL.

However, there will be circumstances where some products, though classified as "financial instruments", will not be regulated under FIEL. For example, a structured deposit with embedded derivatives features will continue to be governed under the Banking Law, and an insurance policy which behaves more like an investment fund will continue to be governed by the Insurance Business Law, and so on. In those cases, those statutes will be amended in line with FIEL so that "financial instruments" are regulated in broadly the same manner, with the same standard of compliance being applicable.

FIEL also expands the types of regulated businesses, which are "Financial Instruments Trading Business" and "Financial Instruments Intermediary Business".
"Financial instruments trading business", essentially covers the conduct, as a business, of:
• The trading of "financial instruments"
• Sales and marketing of collective investment schemes
• Providing investment advice in respect of "financial instruments"
• Providing investment management services or trust services in respect of "financial instruments"; or
• Providing securities administration or custodial services.

"Financial instruments intermediary business", essentially covers introducing brokerage businesses in respect of:
• "Financial instruments"
• Investment management services in respect of "financial instruments"; or
• Investment advisory services in respect of "financial instruments".


Registration requirements
 

One of the key amendments to the current law introduced by FIEL are the new set of registration requirements for regulated businesses.
 

Financial instruments trading business

If a firm will be conducting "financial instruments trading business", it will need to apply for registration for the type(s) of business it will conduct. Set out below are the different registrations available, and the regulated activities which each registration will allow.


"First financial instruments trading business"
• Sale and purchase of securities (but excluding "deemed securities" such as partnership interests)
• Entering into OTC derivatives (securities or non-securities)
• Trading listed securities derivatives (but excluding "deemed securities" derivatives on markets)
• Underwriting issuances of securities
• Operation of proprietary trading systems
• Providing securities administration and custodial services

"Second financial instruments trading business"
• Sales and marketing of collective investment schemes
• Sale and purchase of "deemed securities"
• Trading listed non-securities derivatives
• Trading listed "deemed securities" derivatives

Investment advisory and agency
• Providing advice based on an analysis of financial instruments

Investment management
• Providing investment management services or other similar services in relation to financial instruments


Customer classification
 

FIEL provides for different rules of conduct for transactions with different types of customers.


Customers are categorised into four main types, being "professional investors", "general investors", "professional investors that choose to be treated as general investors" and "general investors who choose to be treated as professional investors".


These customer categories seek to balance the level of regulation required for investor protection while at the same time ensuring the facilitation of business. In general, conduct of business rules designed to ‘level the playing field’ between the regulated entity and its customer are not applicable for professional investor customers. For example, requirements for the regulated entity to provide documentation or information may be exempted. On the other hand, conduct of business rules which are designed to protect market integrity as a whole, such as the prohibition on investor compensation, will remain applicable to all customer types.


Non-Japanese dealers
 

Currently, non-Japanese firms that wish to do business in Japan can either incorporate a subsidiary in Japan and obtain the relevant licences and registrations under SEL, or establish a Japanese branch and register under the Foreign Securities Firms Law. The Foreign Securities Firms Law was legislated because a Japanese branch of a non-Japanese entity was unable to apply for licences and registrations under SEL. This will now change under FIEL so that non-Japanese firms and Japanese firms will be required to obtain the same types of registrations and be regulated under the same statutory framework. Therefore, firms which use the Japan branch structure will be regulated in exactly the same way as local firms.
Like the current law, non-Japanese securities broker/dealer firms which do not wish to establish a local presence can conduct securities business from outside Japan with certain limited Japanese institutional customers.
Offshore investment advisers which are licensed in their home jurisdiction may, without registration under FIEL, provide investment advisory services to investment managers in Japan which are registered under FIEL.
Offshore discretionary investment managers which are licensed in their home jurisdiction may, without registration under FIEL, provide investment management services to investment managers in Japan which are registered under FIEL.


Funds
 

Under the current law, there is a "self-marketing exemption" to registration requirements for securities business. This has been used by an issuer which is marketing securities it will issue - this is not an activity that is regarded as a regulated business itself.


This exemption has led to a practice for funds to be set up as limited partnerships, with the general partner being the fund manager. The fund manager, being the general partner and therefore part of the partnership itself, can then use the "self-marketing" exemption and sell the fund without being registered for that otherwise regulated activity.
FIEL will introduce registration requirements for the self-marketing of funds. As such, the offering of interests in collective investment schemes (shudan toushi schemes), such as self offering of interests in NK (nini-kumiai), TK (tokumei-kumiai) and Japan Investment Limited Partnerships will fall within the new FIEL registration requirements. The party to be registered will be the managing partner of an NK, the TK operator or the general partner of a Japanese Investment Limited Partnership.
While an objective of FIEL is to enhance protection for fund investors, FIEL similarly provides for exceptions where such investors are qualified institutional investors ("QII"). In such circumstances, only a notification requirement to FSA arises, there being no registration requirements mentioned immediately above. A similar exception applies to self-marketing to a "certain limited number of persons". This number is to be determined by Cabinet Order.


Another current exemption under SEL, which will be subject to the new registration requirement under FIEL, is the "self-management exemption". For example in a Japanese Investment Limited Partnership the general partner (who is at the same time, the managing partner) is managing assets co-owned among the said general partner and other partners, and SEL provided exemptions for registrations requirements in such asset management by the general partner. This exemption no longer applies under FIEL, though the QII exception, together with limited persons exception, will be applicable.


Closing comments
 

While the new law has been passed in the Diet, there are many details which will be fleshed out at a later stage in the form of Cabinet Office orders or FSA regulations (drafts of which have not yet been produced), but it is clear that FIEL will bring a wider scope of financial regulation while recognising the need to facilitate business.


It is hoped that this combination of changes will establish a better financial market with improved investor and market protection as well as increased business activity and innovation.

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