Regulatory Framework
Securities Sales Agency Services
New Business Models
Commencing a Securities Sales Agency Business
In Japan, only licensed securities broker-dealers may distribute securities products to investors located in Japan (whether Japanese residents or persons temporarily in Japan), with limited exceptions. Even licensed banks in Japan have only recently been allowed to distribute certain limited types of securities products to investors, such as mutual funds, upon becoming registered as securities distributors with the appropriate Japanese regulators. Under these limited registrations, banks are still not permitted to distribute other traditional equity securities.
Discretionary investment managers (DIMs) who manage investment trusts and other investment vehicles have never been permitted to market securities investment products to investors. The scope of their marketing activity is limited to the marketing of asset management services, and these firms are strictly prohibited from handling or transmitting disclosure or subscription documentation for the purpose of soliciting sales of securities.
Many participants in the Japanese capital market have voiced their frustration with the segmented approach to market regulation which these antiquated Japanese regulations reflect. They effectively prevent the investment adviser who manages the investment product (who arguably has most comprehensive knowledge of such product), from providing information about these products directly to investors. Many fund managers have gone beyond simply voicing their frustrations and have routinely engaged in activities close to, if not actually constituting, solicitation of securities interests without the required securities broker-dealer registration. In so doing they risk the imposition of regulatory penalties. Despite this widespread dissatisfaction among investment managers and advisers with the current situation, Japanese lawmakers have long left these laws unchanged.
Recently, Japanese lawmakers, faced with the stagnation of Japanese capital markets and apathy among investors, have gained in awareness of the fact that some catalyst is desperately needed to revitalize and expand Japan's previously vibrant capital markets. In order to address these concerns, a series of amendments to the existing securities laws have been enacted. Some of these amendments introduce a new method of distribution for securities and mark a significant departure from the previous regulatory regime.
Securities Sales Agency Services
Permitted activities
The concept of agency services for the sale of securities (formally defined in the Securities and Exchange Law as 'securities intermediation services') represents a dramatic departure from the traditional Japanese regulatory pattern for securities sales. Previously, no organizations, other than registered securities broker-dealers registered in Japan, were permitted to engage in securities intermediary activities in Japan. The amendments establish and define the scope of the activities that constitute securities intermediation services and establish the procedures for businesses to follow in order to obtain a securities sales agency licence.
Under the amendments, registered securities sales agency services will be performed by entities entrusted by, and acting on behalf of, one or more of the following principals:
- registered securities broker-dealers;
- registered branches of foreign securities broker-dealers; and
- other financial institutions, such as banks and insurance companies, with special registrations which permit them to market certain types of securities products.
Thus, securities sales agency services will include the following activities:
- intermediary services in connection with securities trading transactions (ie, order taking and intermediation of securities brokerage transactions for execution by securities companies);
- intermediary services in connection with securities index future transactions and securities option transactions on stock exchanges, as well as foreign securities transactions and foreign securities future transactions on foreign stock exchanges, pursuant to Section 2.8.3 of the Securities and Exchange Law (ie, similar activities to those above, but in respect of options and futures transactions); and
- solicitation services on behalf of issuers of their securities offered in both primary or secondary public offerings, and private placements, pursuant to Section 2.8.6 of the Securities and Exchange Law (ie, non-underwriting secondary distribution activities).
Since a securities sales agency is acting as an intermediary for its principal securities broker-dealer, the securities sales agency may only market securities products which the principal securities broker-dealer is permitted to market to investors. For instance, a securities sales agency may not market a foreign securities product to Japanese investors if that product has not been registered by a securities broker-dealer for distribution in Japan with the Japanese regulators.(1)
Although the term 'securities sales agency' is commonly used in the market to refer to these activities, the correct term is 'securities intermediary', as the permitted activities of a licensed securities sales agent are limited to intermediation services between an investor client and the principal securities or principal broker-dealer that the securities sales agency is serving. Consistent with this structure, the actual securities trading contracts and other securities-related contracts are to be made in the names of the principal securities broker-dealer and the investor client.
Required qualifications
All persons other than banks, cooperative financial institutions, trust companies and other financial institutions specified by a Cabinet order will be permitted to conduct securities sales agency services upon obtaining a securities sales agency registration licence from the Prime Minister's Office.(2) In addition to the excluded financial institutions, securities broker-dealers licensed in Japan will also be prohibited from registering as securities sales agents. This exclusion extends to officers and employees of securities broker-dealers and foreign securities broker-dealer branches registered in Japan, and such persons will not be permitted to register as a securities sales agency.
Both corporate entities and individuals are qualified to register as securities sales agents. Sales representatives who are employed by a securities sales agency corporation (ie, the employees with customer contact) are not required to register as securities sales agents as long as the corporation which employs them is registered as a securities sales agency, provided that the relevant sales representatives hold a current sales representative licence obtained through examinations administered by the Japanese Securities Dealers Association.
The following will be qualified to register as securities sales agents:
- non-discretionary investment advisers;
- discretionary investment managers;
- investment trust management companies;
- insurance agencies;
- financial planners;
- commodity brokers; and
- even offshore hedge funds without corporate existence in Japan (with at least one sales representative residing in Japan and having made a foreign corporation registration under the Commercial Code, provided the fund is deemed to be a corporate entity).
Prior disclosures
The securities sales agency will be required to disclose, among other things, the following information to its clients prior to entering into any securities agency services agreement:
- The name of the principal securities broker-dealer that the securities sales agency is serving;
- The fact that the securities sales agency does not have the power or the authority to execute a securities transaction on behalf of its principal broker-dealer; and
- The fact that the securities sales agency may not receive any cash or securities interests, such as stock certificates, from its clients.
Limited scope of business.
A securities sales agency will be prohibited from conducting any securities businesses set forth in Section 2.8 of the Securities and Exchange Law (eg, underwriting, paying agency and similar services), other than the specifically described securities intermediary services activities. However, if a securities sales agency concurrently holds a DIM or investment trust management company licence, that securities sales agency would be exempt from the prohibition and would be permitted to continue conducting activities permitted by the DIM or investment trust management company licence, as the case may be.
Prohibition against receiving and holding cash and securities
Securities sales agencies will be prohibited from receiving and holding cash or securities, such as stock certificates, in connection with their provision of securities sales agency services. In practice this will mean that the securities sales agency will need to arrange with the securities broker-dealer with which it is registered for customer payment and remittance activities, account opening and similar authority in order to be in a position to process transactions. All investment and redemptions by customers will flow directly from the principal securities broker-dealer to the bank account identified by the customer.
Protections against conflicts of interest
Securities sales agencies will be prohibited from disclosing to anyone, including other clients and third parties, information obtained from clients in the course of providing securities agency services. If a securities sales agency concurrently conducts a DIM or investment trust management company business, the securities sales agency will be similarly prohibited from disclosing or otherwise using information obtained in the course of providing DIM or investment trust management company services to or for the benefit of any other person, including securities sales agency services' clients. In order to ensure that these conflict of interest concerns are adequately addressed, a DIM or investment trust management company with a securities sales agency registration must set up an information segregation procedure (commonly known as a 'firewall') between personnel involved in providing the DIM or investment trust management company services, and those involved in providing securities sales agency services.
In addition, securities sales agencies will also be prohibited from conducting proprietary trading activities for their own account using information obtained in the course of performing securities sales agency services.
Reporting requirements
Securities sales agencies will be required to submit annual reports with detailed information about their securities agency business to the Prime Minister's Office within three months of the end of each fiscal year. Annual reports will be available to the public, although certain items may be granted confidential treatment and withheld from public disclosure to the extent that disclosure of such items would harm the securities sales agent's clients.
Principal securities broker-dealer's responsibility
A principal securities broker-dealer for which a securities sales agency is providing securities sales agency services will be responsible for any damages suffered by clients through the actions of the securities sales agency. However, the amendments do provide a safe harbour and relieve the principal securities broker-dealer from responsibility if it exercises due care in entrusting its marketing activities to the securities sales agent, and has taken reasonable steps to prevent the securities sales agent from causing harm to clients.
The amendments were passed by the Japanese National Diet and became law as of May 9 2003. The law will become effective as of April 1 2004.
Offshore funds
Offshore hedge funds typically seek to avoid the additional compliance and related costs of regulation in Japan. The new marketing business models made possible by the amendments and the establishment of the securities sales agency system may appeal to hedge fund entities interested in the Japanese capital markets.
From April 1 2004 the amendments will allow an offshore hedge fund without a traditional securities marketing licence in Japan to conduct substantial marketing activities and promote its investment products to Japanese investors through independently established securities sales agencies. Thus, offshore hedge funds may be able to benefit from marketing activities in Japan through an appointed representative in Japan registered as a securities agency, by forming a securities sales agency relationship with the securities sales agency through the principal registered securities broker-dealer. Under this arrangement the principal securities broker-dealer would be the entity that actually executes the resulting securities transactions.
Although the relevant securities must be registered by the registered securities broker-dealer in Japan in order to qualify them for sale by the securities sales agent, the hedge fund could assist the principal broker-dealer in the preparation of the registration documents and the marketing flyers, offering circulars and other marketing documents. Although the actual execution and settlement of the securities transactions must be performed by the principal broker-dealer, an offshore fund will probably not find this limitation troubling as the fund, in any event, would prefer to outsource these functions and focus more on the actual marketing activities.
Discretionary investment managers
DIMs managing domestic or offshore mutual funds or investment trusts will be able to market such funds or trusts to Japanese investors upon completing a securities sales agency registration as of April 2004. Such marketing activities are prohibited under the Securities and Exchange Law and the Securities Investment Advisory Business Law. Under the Securities Investment Advisory Business Law, a DIM may only market its investment advisory/management services (ie, investment models) to prospective clients and may not market specific securities or securitized products. Thus, under the current regulatory regime, a DIM may not market interests in any securities, including interests in investment funds or trusts that are under the management of the DIM. The amendments address the criticisms directed against the existing limitations by allowing DIMs with the requisite securities sales agency registration to promote and market interests in investment products under their management in Japan. However, as with all other securities sales agency structures, the execution of subscription agreements or other contracts of sale of interests in investment products must be performed between the principal securities broker-dealers and investors.
Investment trust management corporations
Under the current Investment Trust and Investment Corporation Law, investment trust management companies that establish or sponsor, manage and administer investment trusts are only able to market interests in investment trusts that they directly sponsor. The current regulations do not allow such management companies to market interests in investment trusts that are sponsored or managed by affiliated companies, including offshore funds and funds of funds, a sub-fund of which is sponsored and managed by the investment trust management company. However, from April 2004 an investment trust management company with the requisite securities sales agency registration which is a subsidiary or branch of an offshore global investment manager with other offshore funds in various jurisdictions may market not only interests in trusts in Japan directly sponsored by the investment trust management company, but also other investment funds that are sponsored by the affiliated companies (provided they are qualified for sale in Japan through the principal broker-dealer). Thus, the amendments will allow the investment trust management company with the securities sales agency registration to market all investment products of the investment trust management company and its affiliates, both domestic and offshore, regardless of the sponsor of the investment products.
Commencing a Securities Sales Agency Business
Foreign firms that do not maintain a presence in Japan and that wish to benefit from the securities sales agency system would first need to retain an individual who holds a securities sales representative licence issued by the Japanese Securities Dealers Association. This sales representative would then have to register as the representative of a foreign corporation under the Commercial Code with the relevant legal affairs bureau.(3)
The securities sales agency registrant entity must then establish a relationship with a securities broker-dealer licensed in Japan that will entrust its securities marketing activities to the securities sales agency. The principal securities broker-dealer would handle the normal back office functions traditionally performed by securities broker-dealers (including the settlement of transactions and administration of contracts) for the securities sales agent. In practice, it is also likely that the securities sales agency registrant entity would also need to obtain an insurance policy or other form of protection for the securities broker-dealer to insulate it from any potential damages caused by improper securities distribution activities engaged in by the securities sales agency. Although not a legal requirement, relevant securities broker-dealers will most likely require such protection before entering into the type of business cooperation agreements required by the securities sales agency structure.
The securities sales agency registrant entity's representative in Japan (ie, the branch or other representative) will normally apply for securities sales agency registration. The registration procedure is relatively straightforward. The application requires disclosure of the following:
- the name and address of the applicant;
- the names of applicant's officers, if the applicant is a corporation;
- the place of business where the securities sales agency business will be conducted;
- the name of the principal registered securities broker-dealer; and
- any other businesses concurrently conducted.
In addition, the applicant must submit the following documents as attachments to the application:
- an affidavit certifying that the applicant has not conducted illegal securities activities and certain other disqualifying actions for a specified period of time;
- a business method manual or other document describing the proposed method of engaging in the securities sales agency business; and
- if a corporation, a certificate of commercial registration certifying the existence of the corporation.
Other requirements may be added to the above by ancillary ministerial ordinances of the Securities and Exchange Law anticipated to be issued prior to April 2004 (most likely around the end of 2003). The securities sales agency registration procedures will probably be similar to those applicable to the insurance agency registration under the Japanese Insurance Business Law, and will likely require a certificate of sponsorship to be issued from anticipated principal securities broker-dealers. All of the sales representatives employed by a securities agency who conduct actual marketing activities with Japanese investors must obtain a sales representative licence by passing examinations administered by the Japanese Securities Dealers Association.
Upon completion of the securities agency registration, the securities sales agency registrant may market its securities products to Japanese investors. However, before commencing marketing activities, the securities sales agency must have its principal securities broker-dealer register the relevant securities, if required by the Securities and Exchange Law, with the Japanese regulators. In Japan, unless certain limited exemptions apply, securities that are to be offered and sold to Japanese investors must be registered with the Kanto Financial Bureau.(4)
In addition, it is important for asset management firms and groups to recognize that before a DIM or investment trust management company may commence the securities sales agency business, even after obtaining the securities sales agency registration, the investment adviser, DIM or investment trust management company must first obtain a side-business approval from the FSA to conduct the securities agency businesses under its respective governing regulations. Early attention to such side-business registration (preparation prior to December 2003) is advisable, as the number of applicants for the securities sales agency licence is anticipated to be large.
Despite this, an offshore hedge fund can also market its fund interests to investors in Japan through an individual securities sales agency on an independent contractor basis, instead of sending a full-time employee of the fund to Japan and having him/her act as the securities sales agent. The independent contractor securities sales agency business model may also have tax benefits for the offshore fund depending on how it is structured. In order to conduct the independent contractor securities agency business model, an offshore fund would need to locate either an existing securities sales agency or a person with the relevant qualifications to establish a securities sales agency (ie, registered representatives status and relationship with a sponsoring securities company).
Many observers believe that the introduction of the securities sales agency system is the most significant change to the conduct of a securities business in Japan since Japan's so-called 'Big Bang' securities deregulations in 1998, which allowed banks and insurance companies to engage in limited marketing of securities in Japan.
For further information on this topic please contact Koichiro Ohashi(5) at White & Case LLP by telephone (+81 3 3259 0200) or by fax (+81 3 3259 0150) or by email ([email protected]).
Endnotes
(1) This point is especially important to foreign capitalized investment managers who seek registration in order to market foreign funds products in the form of securities, since it will limit the types of products that may be intermediated to offshore securities products that have been qualified for sale in Japan (ie, registered for sale or otherwise qualified for distribution in Japan under the Securities and Exchange Law). Solicitation of the sale of products offered outside Japan which have not been qualified in Japan remains restricted and may not be handled under an intermediation licence.
(2) It is most likely that the registration authority will be delegated to the FSA or local financial affairs bureaux under an ancillary ministerial ordinance promulgated to further the implementation of the amendments.
(3) The recent amendments to the Commercial Code enable a foreign corporation to conduct business in Japan without having a branch office in Japan, as long as a resident representative of the corporation and such representative's residential address is registered in Japan.
(4) These securities registrations may only be filed by licensed brokers-dealers and so close cooperation with the sponsoring securities company will be essential.
(5) The author gratefully acknowledges the contributions of the members of the White & Case-Kandabashi Law Office Hedge Fund Support Desk in the preparation of this article, including the editorial assistance of Christopher P Wells and Carol Tsuchida.