Hedge Fund Regulations in Japan

Relative to other markets such as the US, the regulatory regime in Japan is actually quite favorable towards hedge funds and alternative investments. Hedge funds are deemed to be securities under the Japanese Securities and Exchange Law and are therefore available to all classes of investors. However, this is a double-edged sword. On the one hand, it means that hedge funds can be made available to even individual investors who are free to purchase these products without meeting any pre-determined qualifications. On the other hand, it means that those hedge funds, which are to be distributed in Japan, are subject to the same local registration and reporting requirements as any other security.

There are two central issues with respect to the distribution of hedge funds in Japan. The first relates to the licensing of hedge funds marketers. The second issue relates to the methods of distribution and the form in which the product offering is made.

Marketing Hedge Funds in Japan

There are many unlicensed alternative marketing groups active in Japan. Although it is difficult to verify, some estimate that over a hundred individuals or groups based in Japan operate illegal marketing operations. In addition to these, the countless “fly in – fly out” marketers, including hedge fund managers themselves, are technically breaking the Securities and Exchange Law when they make marketing trips to Japan.

Marketers have been able to get away with this “under the radar screen” approach to marketing in the past. This was because hedge funds and alternative products had traditionally represented only a very minor part of personal and institutional portfolios. With a very visible increase in allocations to alternatives taking place by institutional investors, the bar has been rising at a rapid pace. Hedge fund and alternative investment managers should take heed that the Japanese FSA is beginning to increase its scrutiny of unlicensed groups.

For the first time ever, the FSA recently listed on their website, several unlicensed entities that were involved in marketing investment products to Japanese investors (view).

The focus of the Financial Services Agency posting was on the illegal marketing of funds and whilst regulatory and tax issues may seem a far step from this warning, directed primarily at those selling to retail investors, we anticipate that these unlicensed entities will only be the first of many identified. We expect the FSA to extend their focus and cover other areas including funds management and research.

What is perhaps astonishing, given the growing importance of the Japanese investor base, is that while many hedge funds and alternative investment managers spend considerable resources on meeting US SEC and UK FSA compliance regulations, they often have unlicensed and unregulated agents representing them in Japan. Hedge fund management firms need to be aware of the regulations. Asset managers should also be wary of organizations that position themselves as being only facilitators to a trade. Anytime a buyer and seller are brought together, a license is required.

In line with a general growing awareness of this problem, Japanese institutions are growing more uncomfortable in dealing with agents who are not licensed domestically.

So what avenues do hedge funds have to legally raise money from the Japanese Market? There are several types of licenses, each with their own characteristics.

Investment Advisory License

The Investment Advisory License (IA) allows the license holder to provide investment advice
to both domestic and offshore entities, be they individuals, corporations or financial institutions. An IA licensee may speak to potential clients about investment opportunities and make recommendations concerning investment products but they are not permitted to either take in money to manage or to allocate on a discretionary basis. Neither can they provide fund prospectuses and subscription forms to prospective clients.

Discretionary Investment Management License

The Discretionary Investment Management License (DIM) allows an advisor to actually take in client funds and to manage those funds on a discretionary basis. A DIM may either manage funds internally or allocate funds on a discretionary basis to an outside investment fund such as an offshore hedge fund. As in the case of the IA above, the DIM license does not allow the license holder to provide fund prospectuses and subscription forms to prospective investors for the purpose of selling a specific fund. Those DIMs that have a separate Investment Trust Management license may create mutual funds for sale through domestic distributors such as banks and securities companies.

Securities License

Under the Securities and Exchange Law of Japan (SEL), licensed securities companies and their agents may market and sell investment fund products. Registered securities sales employees are allowed to engage in direct solicitation activities such as the distribution of prospectuses and subscription forms to potential investors. As previously mentioned domestically registered hedge funds are deemed to be securities in Japan and as such are distributed through this channel.

Securities Sales Agents License

The SEL in Japan was amended in 2004 to allow for a new group of sales agents effective April 1st 2004. Primarily created to encourage a wider distribution of investment products throughout Japan, the amendment allows securities companies to expand their sales networks by contracting outside agents to market their products. A securities sales agent must be sponsored by a registered securities company but can be either an individual or a corporate entity. Securities sales agents, as with securities companies employees are also allowed to engage in direct solicitation activities such as the distribution of prospectuses and subscription forms to potential investors.

Banking License

Since 1999, the major commercial banks, and to a lesser extent the regional banks as well, have been a major force in the distribution of publicly offered fund products through their branch networks. In recent years their product offerings have expanded to include hedge fund linked public offerings. In fact their presence in the area of fund of funds linked principal protected funds has been as extensive, and as powerful, as that of the large securities companies.

Trust License

The Japanese Trust Business Law, which governs financial companies that receive fees for managing assets, was revised this year for the first time in eighty years. Japanese trust banks were limited to managing securities, cash, and land but as a result of this amendment, they can now create investment vehicles, including hedge funds and fund of hedge funds. These can be allocated to their individual, corporate and pension fund clients.

Distributing Hedge Funds in Japan

Hedge fund or hedge fund linked products can be distributed in several ways. The method will depend on the scope of the offering and the market segment targeted.

Public Offering

A Public Offering will reach the broadest universe of potential investors. However, it is also the most costly in terms of both the initial offering and the ongoing periodic filings. The Public Offering has been the method of choice for those products that are created for the retail markets, be they the High Net Worth segment or the standard retail segment. Indeed, since the first fund of funds linked principal guaranteed product sold by Yasuda Trust in the fall of 2001, countless numbers of publicly offered hedge fund linked principal protected products have found their way to the market via securities firms and commercial banks.

Small Number Private Placement

The Small Number Private Placement allows for the solicitation of up to 49 potential investors and 250 Qualified Institutional Investors (QII) within a given 6 month period. Virtually all QII’s, as defined by Japanese law, are financial institutions. But there are still limitations. It is interesting to note that not even a cash rich corporation such as Toyota Motor is classified as a qualified institutional investor. Nor are most of the corporate pension funds The registration costs are comparatively low making this an effective way to target a very select and limited number of investors.

Professional Private Placement

The Professional Private Placement allows for unlimited marketing to QII’s and is a more efficient way of targeting a larger number of institutional investors. As with the Small Number Private Placement, the registration costs are comparatively low.

Unsolicited Sales

Finally, as an exception to all of the above, it is legally permissible for a foreign broker-dealer which is authorized abroad but not registered in Japan, to sell investment fund securities including hedge funds to designated institutional investors (which includes most of the major financial institutions in Japan) if and only if the sale is made directly from abroad without any solicitation activities occurring in Japan. In practice however, many third party marketers and, for that matter, hedge funds themselves are coming to Japan and making sales calls on potential investors. They hand out information on the fund, prospectuses and subscription forms in Japan and then claim that subsequent orders were received on an “unsolicited basis”. Hedge fund and alternative investment managers should take care, for although this practice has gone unchecked for a good number of years, many locally registered and licensed entities are beginning to voice their concern to the FSA about these kinds of sales activities that skirt local regulations. More importantly, many of the commercial banks, the regional banks and the smaller financial institutions, are restricted from investing in funds that have not been registered in Japan.

Teneo Partners is a fully licensed Investment Advisory Company. We have recently been granted a Securities Sales Agency License. We anticipate working closely with offshore firms and funds seeking a regulated and licensed presence in Japan.