What Is the Best License for a Private Equity or Hedge Fund Manager in Japan?

In the prior article ¹See 42 BNA Securities Regulation & Law No. 34 (August 23, 2010)(42 SRLR 1601, 8/23/10). in this series (the “Licensing Article”), we explored the various registrations that foreign fund managers and financial intermediaries seeking to operate in the Japan market can obtain under the Financial Instruments and Exchange Law (“FIEL”). That article also considered briefly the comparative financial and compliance burdens associated with each type of registration. This article explores the often difficult decision faced by private equity or hedge fund managers with respect to the question of which of those registrations best fit a fund management firm seeking to establish a market presence in Japan.

Heightened Regulatory Risk for Solicitation Activities.

The decision whether to seek a registration in Japan is often a difficult one for private equity or hedge fund managers. Having experienced almost three decades of lax regulation with respect to capital raising activities in the Japanese market, ²Until the effectiveness of the FIEL from September 2007, many fund managers sought to market securities to Japanese institutional investors under the theory that they were issuers (or affiliated agents of issuers) and therefore were not required to be licensed to market securities under Japan’s then effective Securities and Exchange Law. This so-called “issuer exemption” theory enabled many private equity and hedge fund managers to travel freely to Japan to solicit major institutional funds investors. the passage of the FIEL imposed a much stricter solicitation regime on firms marketing foreign fund interests to Japanese investors.

Recent crackdowns ³See
http://www.fsa.go.jp/en/refer/cold/index.html (blacklist of apparently foreign capitalized firms that are unregistered) and http://www.fsa.go.jp/status/s_jirei/kouhyou.html (summary, in Japanese, of firms sanctioned by JFSA, including for unlicensed solicitation activities). The master list of registered financial instruments businesses can be found at http://www.fsa.go.jp/en/regulated/licensed/index.html. Of particular note are the recent sanctions imposed on Meyer Asset Management discussed at note 16 below. by the Securities Exchange Surveillance Commission (“SESC”) on unauthorized solicitation activities directed at Japanese investors from both in and outside Japan has only heightened the sense that the Japanese capital market is much more difficult to access just at a time when fund managers need to diversify their sources of investors, and Japanese institutional investors desperately need to access higher yielding investment opportunities outside Japan.

Business Model Considerations.

The question of which registration (or combination of registrations) in Japan to pursue depends on the business model of the anticipated presence in Japan including the preliminary questions:

(i) will the presence primarily deal in gathering assets to be invested abroad through investment funds managed by the parent manager abroad (i.e., is the presence dealing with “outbound” financial assets); or

(ii) will the presence primarily deal with issues related to the investment of collectively managed assets in the Japanese market (i.e., is the presence dealing with “inbound” financial assets); or

(iii) will it handle both inbound and outbound financial assets?

This article will focus solely on firms that establish a Japan presence under (i) above.

Core Issues for Outbound Manager Presences in Japan.

Where the Japan presence is involved in raising capital from investors in Japan, it will be important for planning purposes to consider two fundamental questions:

•  (i) for what kinds of securities will solicitation be undertaken; and
•  (ii) what kinds of investors will actually be solicited.

As noted in the Licensing Article, if the relevant securities are paragraph 1 securities, only a registered representative
⁴This term of art refers to an individual who is registered with the Japan Securities Dealers Association (“JSDA”) as a “securities sales representative” holding either a Level 2 (general securities) or a Level 1 (futures and options) sales registration obtained after passing a qualifying examination administered by JSDA. of a Type 1 financial instruments business (“FIB”) will be permitted to make an offer to a Japan resident ⁵This would include foreign nationals resident in Japan as well as branches and subsidiaries in Japan of foreign corporations. investor. Where a paragraph 2 security is involved, in general only a representative of a Type 2 FIB will be permitted to solicit an investment in the security from a Japan resident investor (although there exists a limited exception to this exclusivity under Article 63 of the FIEL). ⁶Application of FIEL Article 63 to solicitation of Japanese Investors by officers, directors and employees of foreign funds (in limited partnership form) acting under what remains of Japan’s “issuer exemption” is sufficiently complex as to be beyond the scope of the discussion herein. Suffice it to note that, subject to the satisfaction of a number of (relatively narrow) factual preconditions, and the filing of a notification under Article 63, qualifying individuals may make limited solicitations of paragraph 2 securities to certain Japan resident investors.

Types of Investors.

General and Professional Investors

The FIEL makes a distinction between “professional” (tokutei toshika) investors (“Professional Investors”) and “general” (ippan toshika) investors (“General Investors”). FIBs that deal with each type of investor are expected to confirm the type of investor they are dealing with and to make appropriate disclosures (including risk, fee and capacity disclosures) for the given type of investor. Such confirmations are made at the point of “client intake” and often coupled with suitability, know your customer and anti-money laundering reviews. ⁷Inspection review of the entire “client intake” process has increased significantly over the past several years and is one of the easiest targets for inspectors due to the high level of technical compliance required to meet Japanese anti-money laundering rules and JSDA rules concerning suitability, “know your customer” and similar requirements.

In principle, individual investors are categorized as General Investors and legal entities are categorized as Professional Investors. However, the FIEL permits FIBs to treat individuals as Professional Investors and legal entities as General Investors subject, in the case of individual Professional Investors, to certain minimum standards ⁸See Article 34 of the FIEL and Article 55 (and, more generally, articles 54 to 64) of the Cabinet Office Ordinance Concerning Financial Instruments Trading Business, Etc. and specific (written) confirmation by the investor of such status in advance of solicitation activities.

Qualified Institutional Investors.

“Qualified Institutional Investors” (“QII”) are an important sub-set of Professional Investors. There are two types of QII:

(i) QII that hold such status by the application of the FIEL and its subordinate regulations (“Statutory QII”); ⁹See the Cabinet Office Ordinance Concerning the Definitions Specified in Article 2 of the FIEL Article 10(1)-(4). and

(ii) QII that hold such status by registering as such with Japanese regulators (“Registered QII”).

Unlike other Professional Investors, QIIs may not elect to become General Investors and are always treated as Professionals.

It is essential that all persons involved in marketing activities in Japan be aware of these basic categories of investors and that they understand and undertake the required actions and make required disclosures applicable to each category. In particular, it should not be assumed that merely because a potential client is a legal entity, it is also a Professional Investor or QII. ¹⁰For example, while it would be natural for the uninitiated to assume that most Japanese pension funds are QII, or at least Professional Investors, in many cases this is not the case. That is, during the client intake process performed by FIBs in Japan, pension funds refuse to confirm that they should be treated as Professional Investors and instead elect to be treated as General Investors.

Confirming QII Status

Many private equity and hedge fund firms determine at an early stage of raising capital in Japan to solicit only QII investors. This determination is advantageous since the universe of QII is well defined with Statutory QII determined by reference to a Cabinet Order under the FIEL ¹¹See Cabinet Office Ordinance Concerning the Definitions Specified in Article 2 of the FIEL Article 10(1)-(4). and registered QII identified on a JFSA Website where registered QII are recorded for public notice purposes. ¹²A list of existing registered QII can be found at http://www.fsa.go.jp. The only problem with the “QII only” marketing strategy is that many targeted investors (notably many pension funds and corporate (non-financial intermediary) investors) have not registered as QII.

Problems with the Type 1 and Type 2 Registrations from a Business Model Perspective.

It might be concluded then that for capital raising purposes, establishing a presence to be licensed as a Type 1 securities firm and/or a Type 2 securities firm would be the best approach. However, many firms feel there are significant problems with this approach:

(i) the staffing (requirement for a full-time compliance officer) to hold a Type 1 registration is costly;

(ii) capital costs (minimum of JPY 50 million and greater than 120% solvency ratio) for a Type 1 registration are relatively high;

(iii) Type 1 firms are viewed as having the most significant compliance, inspection and reputational risks; and

(iv) the market perception of Type 1 securities firms (especially among pension funds) is not always positive ¹³Indeed, anecdotal comments from market participants confirm that many pension funds have a policy of avoiding interaction with marketing staff of Type 1 and Type 2 registrants and prefer only to deal with marketing staff of Discretionary Investment Management FIBs because the Discretionary Investment Manager is believed to be more aligned with the interests of the investor due to the continuing nature of discretionary investment mandates, and the fact that Discretionary Investment Managers are viewed as fiduciaries for their client investors..

Offshore Subscriptions.

Because of the severe restrictions on approaching resident investors in Japan, a practice has developed over the past two decades of seeking to have Japanese resident investors subscribe to alternative investments outside Japan on the premise that such subscriptions would not be subject to these restrictions because of the “territorial” interpretation of Japanese securities laws. The theory of such arrangements is that the Japanese investor voluntarily ventures abroad, submits voluntarily to the laws of a foreign jurisdiction, and subscribes in accordance with the often more relaxed standards of that jurisdiction. The use of this theory of distribution is widespread in the private equity and hedge fund investment world but rests on a set of factual assumptions that can often be problematic in practice including:

• No solicitation of a Japanese investor occurs in Japan and the Japanese investor knowingly relinquishes the protections under Japanese law when making arrangements for subscriptions abroad.
• There is no systematic marketing for the interests in the Japanese market that could give rise to the potential existence of an offering that must be registered under the FIEL.
• The Japanese “introducer” would not be viewed as the agent of the offshore issuing fund for purposes of Japanese laws in handling documentation for the offshore subscription.

• In practice, the activities of informal distributors in the Tokyo markets often go well beyond what the above theory assumes is the level of interaction with resident investors in Japan. ¹⁴Such unlicensed intermediaries often interact frequently with potential investors, carry and furnish to target investors disclosure and subscription materials, and actively assist Japanese investors in processing offshore subscriptions. Prior to the advent of the FIEL, this practice had become so widespread that individuals engaged in distribution were not even aware that their activities require a license or registration, are regulated (and potentially illegal) or the assumptions upon which the offshore subscription model was based. Since the promulgation of the FIEL and active monitoring (and education) of the market by the JFSA/SESC (including enforcement actions) these practices have abated. In order to even minimally satisfy the model, the following requirements must be met:

• The Japanese investor must request subscription material from the offshore fund group directly and that fund group may only furnish offering and subscription material in response to a direct request (and only within the scope of the direct request, that is, information on other products outside of the scope of the request may not be provided without running the risk of an improper solicitation).
• The “introducer” in Japan may not “cold call” the potential investor ¹⁵See note 3 above. in respect of the offshore fund offering; in other words, the distributor must have a credible independent reason for visiting the Japanese investor.
• The “introducer’s” activities in disclosing the existence of an offshore fund investment opportunity must be so occasional that no pattern of systematic solicitation can be discerned that would give rise to the possibility of an offering requiring registration becoming necessary.

Use of the Investment Advisor Registration for Distribution.

Prior to the availability of the FI Intermediary and Type 2 registrations as methods for legitimizing investor solicitation, the most common potentially legitimate method of approaching Japanese investors was through a “referral” approach in connection with a visit by an offshore Investment Advisor to a Japanese investor client or potential client.

Under this theory, the representative of an Investment Advisor would have a relationship as an investment advisor to the foreign fund group and would visit the Japanese investor to seek investment advisory mandates. Upon being refused a mandate by the Japanese investor, the Investment Advisor would indicate that its other client, the offshore fund group, also is interested in learning about what kind of product Japanese investors (such as the investor being approached) would be interested in. Upon learning such details the Investment Advisor would indicate that its client, the foreign fund group, offers such products outside of Japan and would provide contact information to the Japanese investor so that when the foreign fund group received a communication from the Japanese investor, it could argue that it was responding to such solicitation.

This type of indirect solicitation remains in use in Japan although it is obviously contrived and rests on weak theoretical grounds (especially since the adoption of the FIEL and the availability of the Type 2 Securities registration).

The above distribution theory has developed and become common in Japan because of two principal factors:

• the relatively lax enforcement environment for unregistered institutions existing in Japan prior to the adoption of the FIEL ¹⁶It can be argued convincingly that recent JFSA and SESC activity means that the era of lax enforcement has come to an end and that the event that stimulated this major change was the failure of Lehman Brothers, the resulting Financial Crisis and the massive losses suffered by Japanese FIBs on products marketed to investors under the prior lax regime. Of particular note for foreign hedge fund and private equity fund managers is the sanction recently imposed on Meyer Asset Management Ltd. (see http://www.fsa.go.jp/sesc/news/c_2010/c_2010.htm) for the solicitation of Japanese resident investors for investments in foreign investment funds without the proper (Type 1 FIB) registration. Meyer was only registered in Japan as an investment advisor. The SESC sanction imposed apparently includes a business improvement order plus a three months suspension of business (which some observers viewed as a fairly modest sanction in the context). Although the facts of the case are somewhat obscure, the case can be seen as standing for the proposition that foreign funds should be wary of dealing with “introducing agents” and similar firms that are either unregistered, or registered only as investment advisors, with respect to any securities distribution activities. The case appears to have been a “wake up call” to the entire fund distribution community in Japan.; and

• the considerable expense associated with filing the registrations for offshore fund interests required to qualify the foreign fund interest for sale to Japan resident investors in a private placement.

Indeed, it has been observed that the above rules have been rigorously observed principally by financial intermediaries with reputation concerns and are less closely adhered to by smaller distributors. For institutions concerned with reputational exposures, avoiding regulatory problems in Japan is relatively straightforward: (i) appropriately register financial products for distribution in Japan; and (ii) sell such products only through appropriately licensed distributors and placement agents (i.e., Type 1 and Type 2 FIBs and FI Intermediaries).

Use of the Investment Management Registration to Raise Capital.

Prior to the Global Financial Crisis, major Japanese financial intermediaries such as commercial banks, trust banks and insurance companies were major allocators to private equity funds and hedge funds. ¹⁷Unlike in some other jurisdictions, historically the major Japanese investors in private equity funds have been institutional investors, not high net worth individuals and endowments. The fact that over 55% of the personal financial assets of Japanese are represented by bank deposits (compared to less than 7% in mutual funds), made Japanese banks the logical target for capital raise activities by international fund groups from the late 1990s. With the early and aggressive application of Basel II capital adequacy standards to Japanese banking institutions from 2005, new allocations by these sources had slowed significantly by 2007 (with one or two notable exceptions) and reversed to substantial redemptions during the Global Financial Crisis. Although in the past six months some allocations have commenced again, it appears very unlikely that these investors will be a substantial source of capital for private equity and hedge funds in the near term. Rather, since the Global Financial Crisis, Japanese pension funds have emerged as the most recent source of investment fund capital.

Approaching Pension Funds

As noted above, pension funds in Japan have very long (in some cases over 50 years) relationships with Japanese trust banks and, since the late 1980s, with Japanese asset management affiliates of international banking groups. Because of this, pensions funds have the greatest experience with, closest relationships to, and feel most aligned with the interests of, investment managers licensed to conduct an Investment Management business in Japan. As a result, over the past 12 months private equity and hedge funds have considered obtaining an Investment Management registration to be an increasingly attractive alternative for raising capital in Japan.

Problems with the Investment Management Registration for Offshore Firms

However, there are elements of the Investment Management registration that make it less than ideal as a licensing alternative. First, the Investment Management registration does not provide any authority to market investment fund products; it is a “mandate seeking” (on the marketing side) authority rather than a license to sell existing managed fund products. Thus, the Investment Management firm must market its fund management capabilities by seeking investment management contracts rather than investment product sales.

A second problem with the Investment Management registration for international fund managers wishing to establish a foothold in Japan is the widely held view ¹⁸This view is especially prevalent among the notoriously conservative members of Japan’s regulatory bar. that the registration requires that Investment Managers actually perform portfolio management services (the core element of the license) through the Japan presence. While the level of such activity in Japan can be modest compared to capital raise marketing activities, the need to actually conduct investment activity in the Japanese presence is viewed as inconvenient, burdensome and possibly risky by many global fund management groups.

A third problem with the Investment Management registration for capital raise activities is that the FIEL prohibits registrants from entirely sub-delegating their asset management responsibilities offshore. ¹⁹See FIEL Article 42-3(2). This provision has been variously interpreted over the years (the same provision existed in the Investment Advisory Business Law before that law was incorporated into the FIEL), but all responsible commentators agree it means at least that the Investment Manager will take responsibility to the Japanese investor for the actions (conformance to investment guidelines and best practices) of the offshore manager and that it has a duty of care to monitor the activities of the offshore manager (and can terminate the mandate immediately upon the occurrence of a problem). Unfortunately, many global fund managers do not understand that their Japanese subsidiaries have a duty to monitor their parent firm’s management activities in a meaningful manner and to demonstrate this to inspectors in Japan (rather than the reverse).

Use of Placement Agents.

If you are a legal person or compliance officer who has read this article to this point you may be forgiven for feeling frustrated by the above litany of reasons that each of the four registrations under the FIEL do not work well for your marketing business model. The reality is that no one registration addresses all the requirements for capital raising activities that typical offshore fund managers desire.

This fact has been understood by foreign retail mutual fund groups active in Japan for many years. These firms (including relevant European “universal” banks and investment bank affiliates engaged in asset management activities) by necessity have had to obtain all of the main FIEL registrations as their marketing activities have expanded in Japan. Contrary to the views of some observers, this should not be interpreted as Japanese protectionism. The reality is that domestic financial intermediaries are often as frustrated as their foreign counterparts by the need to have multiple registrations to market investment fund products to investors in Japan.

It is due to the above frustrations that experienced advisors in the Japanese market recommend teaming up with a local placement agent holding the relevant Type 1 or Type 2 registration to market their products in Japan (or to use an established Investment Manager to approach pension funds) as an initial stage of market entry in Japan.

The use of an established placement agent in Japan does not prevent the foreign fund group from having staff on the ground in Japan provided such staff do not engage in product solicitation of fund mandate seeking activities (which are regulated). These “support service” offices are typically modest in size and limit their activities to interfacing with placement agents for their offshore parent firms and assisting in the design of marketing programs including answering investor questions about existing investments (typically through the placement agent). Unfortunately, however, such “support offices” do not work well to establish the direct and continuing relationship with investors that private equity and hedge fund managers desire because the relevant staff cannot discuss potential additional fund investments with clients.

“Chaperoning”

It should be noted that unlike in some other jurisdictions, the practice of “chaperoning” (an unregistered representative of the private equity or hedge fund accompanying the placement agent to “pitch” Japan resident investors) is not permitted in Japan. Under Japanese rules, only a registered (with JSDA) securities sales representative ²⁰See article #2 in this series “Regulatory Registrations Under the Financial Instruments and Exchange Law” 42 BNA Securities Law & Regulation No. 34 (August 23, 2010). of a registered securities firm may make an offer for the purchase or sale of securities and/or explain the details of such offer to an investor.

This rule has led to the practice of “expert explanation” in which the registered representative of the placement agent brings a representative of the fund group to meetings with prospective investors and then seeks the “expert explanation” of the unlicensed fund group representative with respect to the details of the potential investment. It should be noted that under this paradigm the investment fund representative does not direct explanations to the potential investor, but rather those comments are directed to the placement agent’s registered representative who then communicates them in his “pitch” to the investor.

“Secondment” Arrangements

Another approach to directed marketing to Japan resident investors is the secondment of a representative of the fund manager to the placement agent for a fixed period of time ²¹The period is typically two to three years on the presumption that it takes at least a year in Japan to develop relationships with representatives of major allocators. typically on the understanding that the relevant individual will focus on marketing the relevant investment fund’s products in light of his or her experience and expertise with the fund group. During the period of secondment the given individual is under the compliance and managerial supervision of (and is employed by) the placement agent.

Secondment arrangements such as those described above are rare in the Japanese market because of the following factors:

• The relevant marketing individual must be willing to move to Japan and work in a Japanese FIB’s work environment (which can be very different from that of a non-Japanese firm);

• The individual must move off the foreign payroll and become a true employee of the Japanese FIB (including its benefit programs) and leave the employment and benefit programs of the originating firm (i.e., the employment relationship with the foreign firm is severed and only a promise of future employment offshore remains);

• If the firm is a Type 1 FIB, the individual must either already be registered with the JSDA as a securities sales representative or must pass the sales representative examination for the types of instruments that will be marketed;

• Concern on the part of the originating fund firm that it could lose contact with the seconded staff over time; and

• Reluctance on the part of the compliance staff of the FIB to take responsibility for compliance issues involving an employee who may not feel any allegiance or responsibility to the FIB and who is likely to place the originating firm’s interests ahead of those of the FIB.

Conclusions and Recommendations.

As noted above, there is no clean “one size fits all” solution for a Japan presence engaged in capital raising activities. For this reason, considerable thought and planning should precede the decision to establish a presence in Japan for these activities. Among the questions that should be considered (and answered with a “strong yes”) are:

• Is it likely that substantial new fund allocations can be realized by establishing a Japan presence (i.e., solid market research concerning demand for the strategy, etc. should precede the initiative in Japan)?

• Can our group achieve the same level of placement success through a placement agent or should we work with a placement agent to establish a “beach head” in Japan before investing in a local presence?

• Can we achieve our investor base goals through an unregulated presence working with firms that have the relevant registrations?

• Is the cost of hiring and housing experienced personnel justified by the amount of capital likely to be raised?

• If we must have a registered presence, which registrations do we need to carry out the relevant activity and is the cost/benefit ratio for each additional registration justified? and

• Can we find a professional or (or is the person we have identified) prepared (and sufficiently experienced) to work in a newly established regulated financial intermediary in Japan (i.e., without any onsite compliance and managerial supervision)?

If and when all of the above questions can be answered with a “strong yes” we look forward to welcoming your firm to the Japanese market and hope this article will help you formulate a strategy here.