Deregulation of Japan's Asset Management Industry Affects Funds

Washington, DC, July 9, 1998 - Regulatory changes currently being made in Japan may affect the investment trust (mutual fund)¹ and pension management industries. Provisions that will take effect on December 1, 1998 are expected to significantly open Japan's investment trust industry to foreigners.

Background: The Big Bang
In late 1996, Japanese Prime Minister Ryutaro Hashimoto announced an ambitious plan to reform six areas of the Japanese economy, including the financial system and the investment trust industry. The "Big Bang" initiative has resulted in numerous proposed reforms developed by the Financial Supervisory Agency's (FSA)² predecessor, the Ministry of Finance (MOF), to make Japan's financial system "free, fair and global." The first reforms went into effect on April 1, 1998. A second set of reforms, entitled the Financial Systems Reform Law, were enacted by the Diet on June 5, 1998, and are scheduled to go into effect on December 1, 1998. Other reforms are set to be adopted in stages over the next five years, although the timetable is not entirely clear.

The Big Bang is intended to deregulate and otherwise enhance all aspects of Japan's financial system and to significantly open Japan's financial market to foreign participation. Although the primary focus of Big Bang is on the mounting problems faced by Japan's banks,³ it will significantly affect the laws⁴ and rules⁵ governing investment trust companies (ITCs), investment trust management companies, and other investment advisers.This is particularly true with respect to the provisions of the Reform Law.

Major Elements of the Reform Law
1. Expansion of Distribution Channels
The Reform Law significantly liberalizes the distribution of ITCs in Japan by permitting, after December 1, 1998, banks and other financial institutions to distribute shares of domestic ITCs and offshore funds directly. Traditionally, ITC and offshore fund shares were distributed solely through brokers.⁶

2. Introduction of Corporate Type Funds
All ITCs are currently organized as contractual-type funds under a trust deed, typically having a limited existence. The Reform Law introduces corporate-type funds similar to US mutual funds as of December 1, 1998. This structure is expected to become popular in part due to a corporation's ability to have a perpetual existence.

Japan's tax law is also being amended to give corporate-type funds equal tax treatment to contractual-type funds.

3. Introduction of Private Placement Exemption for ITCs
The Reform Law introduces the concept of a privately placed ITC for the domestic Japanese market, including the corporate pension plan market. Regulations will be adopted prior to December 1, 1998, detailing the scope of the exemption.

4. Delegation of Investment Management Permitted
Through an amendment to the definition of "discretionary contract," a licensed investment adviser will be permitted after December 1, 1998, to transfer the discretionary authority obtained from its customer to another licensed adviser or others specified by Government order. The FSA is authorized to adopt rules implementing this amendment.

The change permits investment trust managers to delegate discretionary investment authority to sub-advisers, which would provide US companies engaged in investment trust activities in Japan with the ability to use the services of their overseas affiliates in servicing Japanese investment trusts.⁷

5. Change from Licensing to Registration System
Domestic Investment Advisers and Investment Trust Managers. Investment advisers and investment trust management companies in Japan currently must obtain licenses from MOF. After December 1, 1998, firms will be permitted to engage in these businesses subject to notification to and approval by the FSA.⁸ This is intended to change the current licensing process to a registration process, streamlining it and reducing the amount of regulatory discretion and delay involved.

ITCs. MOF approval also is currently required for each ITC trust deed and any amendments thereto. After December 1, 1998, disclosure rules under the Securities Exchange Law will apply to trust deeds and MOF approval will no longer be necessary.

Foreign Investment Advisers. An investment adviser that provides discretionary investment advice in Japan currently must have a permanent place of business in Japan and must be licensed to do business by MOF. Similarly, an investment adviser that provides non-discretionary advice in Japan must be registered in Japan. As of December 1, 1998, these requirements will not be applied to licensed foreign advisers, defined as companies that are organized under foreign laws and that are licensed to conduct discretionary investment activity in a foreign country, that provide advice only to licensed advisers and others specified by government order. It is expected that the FSA will adopt rules implementing these changes.

Easing of Restrictions on the Sale of Offshore Funds
Under MOF guidelines, the sale of offshore funds in Japan has been limited to funds that are denominated in a foreign currency, have the majority of their assets in securities (as defined under the Securities Exchange Law), and are at least one-sixth owned by foreign investors at the time of the initial offering in Japan. In addition, offshore funds sold in Japan must meet qualification standards established by the Japan Securities Dealers Association (JSDA). These qualification standards include, among other things, the requirement that offshore funds sold in Japan must be domiciled in an OECD member jurisdiction and must not invest more than 10% of their assets in other investment trust securities (as defined by the JSDA).

After December 1, 1998, the only one of the MOF guidelines that will remain is that offshore funds have a majority of their assets in securities (as defined under the Securities Exchange Law).

7. Glass-Steagall Type Reform
On April 1, 1998, a 50-year old ban on financial sector holding companies was lifted. However, consolidated tax payments are not yet allowed, meaning that there is little tax incentive to reorganize into a holding company structure.

On December 1, 1998, a single company will be permitted to conduct investment trust management, investment advisory, and broker-dealer businesses. The three businesses traditionally had to be conducted in separate entities, although since 1995 it has been permissible for a single company to conduct investment trust management and investment advisory businesses. With respect to the investment trust industry, this reform is expected to facilitate the development of wrap accounts.

In 1999, securities companies and trust banks will be allowed to enter each other's businesses through subsidiaries. By the end of 2001, insurance companies will be included, so that securities companies, trust banks, and insurance companies will be allowed to enter each other's businesses through subsidiaries. All remaining barriers between the different financial sectors are to be removed by the end of 2001. These reforms are likely to increase competition and foster the creation of universal financial services companies.

8. Rules Relating to Structure and Operation of ITCs
The Reform Law requires regulations to be adopted prior to December 1, 1998, with respect to the organization of ITCs (including regulations on meetings of investors, officers, and directors), accounting, liquidation, and mergers. Independent audits of ITCs likely will be required under the new regulations.

9. Aggregation of Orders
The aggregation or "bunching" of client orders will be permitted for the first time as of December 1, 1998.

Major Elements of the April 1 Reform Package
1. Relaxation of Foreign Exchange Controls
A multitude of restrictions on capital movements in and out of Japan were lifted as of April 1, 1998, including restrictions preventing non-banks from conducting foreign exchange business. In addition, prior approval for foreign exchange transactions is no longer necessary and the legal status of "netting"- a practice whereby several different transactions are consolidated to save money-has been confirmed. The effects of these measures could be significant, particularly with respect to Japanese investors, who are now free to place their assets in high-yielding bank accounts, investment trusts, or insurance contracts anywhere in the world.

2. Partial Liberalization of Brokerage Commissions
As of April 1, 1998, commissions for transactions over 50 million yen were completely deregulated. Analysts are forecasting that commissions could fall by as much as 50%. Commissions for transactions below 50 million yen will be liberalized sometime in 1999.

3. Adoption of a System of "Prompt Corrective Action"
A new system of bank accounting and monitoring, known as "Prompt Corrective Action," has been introduced. Banks will be subject to greater disclosure requirements and may be shut down by Japanese authorities if they do not have sufficient financial strength.

Remaining Issues
It remains unclear whether, or how, certain other issues will be addressed.

1. Pricing, Valuation, and Performance Issues
The Japanese system of pricing portfolio securities, calculating net asset values, and reporting performance is very different from that of the US. Shares of an ITC are not sold at net asset value like US mutual fund shares, but at a price that takes into account "averaged trust money" and the withholding tax liability borne by the ITC's shareholders.⁹ Moreover, the net asset value of an ITC not only reflects the performance of the ITC's underlying securities (priced generally in accordance with US standards) and any distributions made by the fund, but also an adjustment based upon purchases, redemptions, and the averaged trust money/withholding tax calculation.¹⁰

The resulting system produces anomalies. An existing ITC that has good performance and attracts new shareholders, for example, will find its net asset value decreasing as it sells shares to new investors regardless of the performance of the ITC's portfolio.¹¹ (This decrease might be partly responsible for the absence in Japan of an effective performance reporting system.) In addition, the system appears to produce an incentive to purchase shares of an ITC that has depreciated in value by creating a built-in withholding tax credit for such ITCs. Since new or appreciated ITCs do not have the same advantage, there seems to be a corresponding disincentive to the purchase of their shares.

2. Need for Exceptions to Prohibitions on Funds of Funds
JSDA rules prohibit an offshore fund from being sold in Japan if the fund has more than 10% of its assets invested in investment trust securities, as defined by the JSDA. (A similar restriction applies to domestic Japanese ITCs.) As a result, it is not possible to use a master-feeder structure in Japan or develop the types of asset allocation "funds of funds" permitted under the recent amendments to US law made by the National Securities Markets Improvements Act of 1996.¹²

3. Pension Issues
Several changes to Japan's pension laws are being considered or will be considered next year.

Introduction of Defined Contribution Plans. The Ministry of Health and Welfare and the Pension Funds Association are actively studying defined contribution schemes in connection with a pension legislation package due to be enacted next year. Whether a proposal introducing defined contribution plans will be included in next year's amendments or what form such a proposal would take is unclear.

Access by Investment Advisers to the Management of Nempuku Investments. Pension reform likely will include changes that will streamline the "Shiteitan" structure under which discretionary investment advisers are permitted to manage public pension assets in Japan.¹³ The Shiteitan structure involves the creation of a partnership and a complex series of contracts involving a trust bank, investment adviser and Nempuku.

Repeal of the "Cash In, Cash Out" Requirement. Each investment adviser that receives a mandate to manage Japanese pension assets currently must be given cash to manage. This effectively requires the liquidation of the pension assets that relate to the mandate upon any change in investment advisers, needlessly incurring transaction costs to the extent that the new investment adviser repurchases any securities held by the previous investment adviser and creating a barrier to competition for mandates.

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In large part, the Big Bang is intended to reduce regulatory discretion and increase transparency in Japan's regulatory regime. Provisions in the Reform Law (such as the movement from licensing to approval) may have that effect. However, many of the rules and regulations required to implement the new laws have not been drafted and it remains unclear whether private industry will have appropriate notice and an opportunity to comment.

¹Domestic Japanese mutual funds are called "investment trust companies" and their managers are called "investment trust management companies."

²The FSA began operations on June 22, 1998, under the auspices of the Office of the Prime Minister. The FSA will largely replace the Ministry of Finance as the regulator for the invesmtent trust and investment advisory industries.

³The banking reforms in the Big Bang provide greater autonomy for the central bank and reform its operations, implement measures to deal with non-performing assets and bank failures, strengthen disclosure requirements, and reform accounting practices and standards to promote greater transparency. Many of these measures were reiterated in the bank reform package announced on July 2, 1998 that included the government's "bridge bank" initiative.

⁴These laws include the Investment Advisory Business Law, Securities Investment Trust Law, and Securities Exchange Law.

⁵The FSA is required to promulgate rules prior to December 1, 1998 to implement certain provisions of the Reform Law. The Japanese Securities Dealers Association (JSDA), Japan Securities Investment Advisers Association (JSIAA) , and the Investment Trusts Association (ITA) have self-regulatory responsibilities over their members. The JSDA and the JSIAA are revising their rules to conform to Reform Law provisions. It is unclear whether the ITA will revise its rules.

⁶Since early 1997, ITCs have been able to distribute their shares on bank premises by leasing space in bank lobbies for ITC kiosks.

⁷Currently, overseas affiliates may only provide recommendations because all discretionary investment decisions must be made in Japan.

⁸Non-discretionary advisers file notices under the Securities Investment Trust Law; discretionary advisers, such as investment trust managers, file notices under the Securities Exchange Law.

⁹Withholding tax rates vary based upon the form of the ITC's organization (contractual or corporate) and whether it is onshore or offshore.

¹⁰Shares of an ITC are sold at a "trading base price" that takes into account the withholding tax liability assumed by the new shareholder as part of the share purchase.

¹¹In an appreciated ITC (where redeeming shareholders will pay a withholding tax), a new shareholder would pay less than net asset value for shares but would also assume some withholding tax liability. The net asset value next computed would be reduced, in essence, to account for the "sharing" of withholding tax liability among the existing and new shareholders.

¹²See sections 12(d)(1)(E) (with respect to master-feeder funds) and 12(d)(1)(G) (with respect to asset allocation funds within a fund complex) of the Investment Company Act of 1940.

¹³In Japan, public pension assets invested in the securities markets are managed by the Pension Welfare Service Public Corporation (Nempuku). The Financial Services Agreement entered into between the US and Japan in 1995 included a provision requiring the Shiteitan structure to be reviewed "at the time of the next comprehensive review of the Japanese pension system in 1999."