The financial regulations in Japan have been the subject of significant reforms over the last few years. In line with increased regulatory scrutiny experienced across numerous global financial markets, the Japanese regulatory environment has been evolving. In the area of securities distribution, this trend is not only in response to general global movements, but also to a number of significant sanctions cases that have pressured the regulators to impose greater controls and regulations. In particular, the regulators have been focusing on illegal marketing and fund-raising activities in Japan.
There have been two particularly prominent cases in Japan where the Securities and Exchange Surveillance Commission (SESC) has found firms to have engaged in unregistered fund-raising and fraudulent marketing practices.
MRI International Case
In the first case, sanctions were issued by the SESC in April 2013 against MRI International Inc. (MRI), a foreign firm registered in Japan as a Type II Financial Instruments Business Operator (a Type II registrant). MRI solicited and sold interests in fund vehicles that were to purchase medical accounts receivables in the United States and pay its interest holders distributions out of profits earned from collecting on such receivables. Although MRI claimed that investments would be separately managed through trusts and other accounts, the SESC found that funds were commingled and the greater portion of the funds that should have been used to acquire new accounts receivables were instead used to pay dividends to prior investors, in a classic Ponzi scheme reminiscent of the Madoff scandal in the United States.
Although the actions of MRI can be attributed to a bad player acting in a fraudulent fashion, the regulators did recognize that the relatively lower degree of oversight exercised over Type II registrants contributed to these frauds. One regulatory consequence arising from the MRI case was that, as of this last summer, each Type II registrant going forward will be required to join the new self-regulating Type II Financial Instruments Firms Association (Type II Association) or establish its own, extensive internal rules and policies that are equivalent to the Type II Association rules (typically a very expensive exercise). Moreover, the Type II Association registration process is onerous and relatively expensive and unprecedented for Type II registrants. This change has led to certain Type II registrants re-evaluating their business models and, in some instances, electing to surrender their Type II registrations altogether.
Another informal development arising out of the MRI case is that there appears now to be greater scrutiny of compliance officers for Type II registrants who are not native Japanese speakers. In the past, a fairly common approach to fulfilling the compliance function was to appoint a group Asia compliance officer as a Type II registrant’s compliance officer. The theory had been that for Japan law–specific matters, the compliance officer would rely on the assistance of local Japan counsel for guidance. Going forward, however, it appears that regulators will scrutinize the compliance officer’s concrete knowledge of Japanese regulations and practices and review specific steps taken to educate, and maintain the capability of, the compliance officer.
Abraham Private Bank Case
The second case, with far-reaching ramifications, is the Abraham Private Banking (APB) case for which sanctions were issued in October 2013. APB held the Investment Advisory and Agency Business registration, which allowed APB to provide non-discretionary investment recommendations based on the value of securities to its clients. However, rather than simply providing investment advice, APB provided explanations, descriptions, and application documents for specific foreign investment securities. The information provided included specific details such as investment terms, prices, and benefits and risks of the foreign investment securities. The documents discussed with investors included actual subscription forms and agreements. In addition, APB’s fund-raising activities were conducted on a mass level, targeting retail level investors and advertising widely through magazines, TV commercials, Internet advertisements, and advertisements on trains. Through these tactics, over the course of a few years APB rapidly increased its number of clients into the thousands.
Although APB did not directly receive commissions from the foreign investment securities issuers whose securities it marketed to its retail clients, compensation was paid by either the foreign investment fund itself or an investment manager (of the foreign fund) to a “shell company” in the British Virgin Islands named Sagacious Trend International (STI). STI was founded and owned by the board of directors of APB. The amount paid by the foreign investment securities issuers to STI correlated to the purchase price paid by the APB clients. The SESC rightly found that this arrangement amounted to APB receiving commissions for its marketing activities. In addition to unregistered marketing and fundraising activities, the manner of APB’s advertising was also highly problematic with numerous false or misleading claims. One instance of this was that APB placed advertisements in magazines, advertising its advisory services and compared results of products it handled against other products offered by domestic securities companies and domestic investment trust companies over the last five years. The APB serviced products showed the highest average annual yield of 15.34%. However, upon examination, the reality was that although it may have been possible for an investment product available to APB’s clients to realize an annual yield of 15.34% over the past years, there was no record of any APB client actually having received any such recommendation to invest in such product.
Beyond these unregistered and problematic activities, the APB case was aggravated further by the fact that APB had marketed investment products to thousands of retail clients. While marketing activities by independent financial advisors (including registered investment advisors) without securities licenses may have occurred on a limited basis in the past and not attracted much notice, the APB case has forced the Japanese regulators to address these types of programs.
As a result of the APB case, the Japanese regulators have placed increased scrutiny on unregistered solicitations and sales, both with respect to the issuers of the foreign financial products involved and on the distributors of these products. The Japanese regulators are also taking a much more proactive approach towards ex-Japan participants who deal with Japanese investors. For offshore issuers, even if not intending to offer its products in Japan, it should be noted that if there are greater than 50 Japan offerees, and there is some organized offering program, the issuer can be deemed to have conducted an illegal public offering in Japan. Simply claiming that the issuer was approached outside of Japan by Japanese investors is unlikely to be accepted by Japanese regulators when there are thousands of Japanese retail investors involved.
We believe that APB is a particularly significant case, as it demonstrates that unregistered offering and solicitation activities will be sanctioned in Japan. Although there have been various schemes for participants in the past to fund raise in Japan without adequate registrations or registered distributors involved, with these recent cases, such actions run very significant supervisory and reputational risks. The SESC rejected the use of the investment advisor registration to provide support service to subscribe for offshore securities (i.e., it is an intermediation for securities distribution) and found that APB was marketing offshore securities interests requiring that APB possess a Type I or Type II Financial Instruments Business registration. So for market participants seeking to raise funds from investors in Japan, it is now clear that such participants need to either obtain a Type I or Type II registration themselves or engage a Type I or Type II registrant.
It should also be noted that the SESC is scrutinizing a number of non-traditional securities, such as savings products and insurance products. While the sale of insurance products is heavily regulated under Japanese insurance laws, recently various insurance-like products have also been coming under greater scrutiny. In particular, it should be noted that some products may be characterized as securities by the Japanese regulators, even though they may not be characterized as securities in their home jurisdictions. For market participants dealing in these types of products, if there are Japanese investors involved great care must be taken prior to any such issuances in Japan to ensure that the participants are not found to have engaged, albeit unintentionally, in an illegal securities offering in Japan.
The APB and MRI cases have demonstrated to the Japanese regulators the necessity of looking beyond Japan to ensure that Japanese investors are appropriately protected, and we expect this trend to continue. As such, we would recommend to institutions currently involved or considering involvement with Japanese market participants to examine closely their structures and ensure that their activities fall within the scope of permitted registered activities.