Japan 2007: Controlling hedge funds
The Financial Instruments and Exchange Law, which changes the regulations governing the Japanese hedge fund industry, came into force in September. There is still considerable debate about what the implications of the law will be. It should be a boon to hedge fund managers but there are concerns that it will increase the regulatory burden. Hugo Cox reports.
In the Financial Instruments and Exchange Law (FIEL) which became effective in September, will have far-reaching implications for the Japanese hedge fund industry. On the face of it, the law gives Japan’s hedge fund managers – typically based in Hong Kong or Singapore – greater freedom to take on money from Japanese investors in exchange for notification with the Japanese regulator. But the implications of this move, which would in theory bring offshore managers under some degree FSA control, may be more onerous. The fear is that the threat of further regulation could drive existing managers away from taking on Japanese investors and may make global managers think twice about entering this market.
The new regulations are also putting the tax status of offshore managers with considerable research outfits in Japan under the microscope. Despite the regulator’s repeated assurances to the contrary, there is a fear that such managers and their investors could become liable to onerous domestic tax treatment, which would be disastrous for the industry. Additionally, there is no guarantee that one of the guiding principles behind the reforms – to make it easier to detect and punish hedge fund manipulation of market – can be implemented when so many of funds are based abroad so are outside of the FSA’s control.
The principal benefit to hedge fund managers under the new legislation is that the managers wishing to enter Japan will be given limited access through a very simple notification process. This enables managers to avoid the typical six-month wait for approval and the costly inspection and ratification process required to obtain a “discretionary investment management” license.
It also means foreign managers will not be forced to rely on the services of specialist onshore intermediary firms to distribute their funds. These typically take a portion of the equity interest in the fund on to their books and then sell derivative interests to investors, charging anything up to 3% and an ongoing percentage of NAV for the service.
This regulatory easing should hep spur growth, said Naohiko Matsuo, former director of FIEL responsible for drafting the new legislation. ‘The changes make entry for foreign managers to Japan easier, enhancing competition to the benefit of investors at home and abroad.”
The flip side of this greater freedom is that offshore managers that wish to solicit Japanese investors will now have to notify the FSA under Article 63 of the new law or apply for the far more regulated discretionary management licence. This is a major tightening of the previous SEL arrangement, under which managers could raise assets without notification.
The notification process presents no problems, per se. It comprises a simple form – in English, a first for Japanese regulators – requiring basic information such as the managers’ name, the name of the CEO, the fund’s AUM, registration address and the like. But while filing notification is simple, it is feared the implications of so-doing could be much more onerous.
A primary concern for fund lawyers is that notification appears to place managers under FSA supervision, meaning further questionnaires could be sent out. “Historically these survey reports have been extremely simple,” said Chris Wells, a Tokyo-based partner at White & Case, and chairman of the Regulatory Committee for the Japan chapter of the Alternative Investment Management Association. “But it is possible that they could become more complex and burdensome going forward as the FSA increases scrutiny of this part of the market.”
And Matsuo agreed that regulators would be willing to use the reporting route to scrutinise managers about whom concern has been raised: “If there are problems on specific fund managers who have made notifications to the FSA, the FSA has a right to require reporting from them.”
Notification would also constitute the manager consenting to give the FSA inspection rights. In practice, the FSA is unlikely to inspect a UK or US-based fund without the co-operation of American or British regulators, but the potential for increased regulatory reporting and compliance arising from this is sufficient to make hedge funds’ in-house lawyers uncomfortable.
So how will this affect hedge fund managers and investors? Wells said the main risk was that Japan could lose out with the large global hedge fund groups currently without a Japanese investor base but considering entering that market. “The large US fund groups considering taking on Japanese money may worry about the burden of having yet another regulator on their back,” he said.
Kiyotaka Sasaki, director of strategy and policy co-ordination at the Securities and Exchange Surveillance Commission (SESC), said that the new legislation was already having an effect. “There is certainly concern among managers, with some already leaving to base their operations entirely abroad.”
Japanese investors are also anxious. “One of our investors recently raised a concern that he would not be able to allocate to a fund because it wasn’t registered under the new rules,’ said Tomoharu Kabe of Deutsche Bank’s Prime Finance Sales team in Tokyo.
Meanwhile, prime brokers are considering which way to advise clients as these types of investor queries make the rounds of compliance and internal legal teams. Most such queries are yet to be resolved, with firms making full use of the remaining three months until the required notification must be provided to the FSA.
Tax time bomb
Offshore funds with a considerable research presence in Japan, which under SEL claimed exclusion from Japanese tax on the grounds of their trading operations being located offshore, will also come under increased scrutiny
Historically a tough Japanese tax regime has meant that most Japanese hedge funds set themselves up in Hong Kong or Singapore. With onshore Japanese managers facing corporation tax of up to 40% and investors a 20% withholding tax extending to up to 50% on fund profits, the appeal of Hong Kong and Singapore – where corporation tax is 15% and 20% respectively – is unquestioned.
What concerns the regulators is that the onshore Japan offices of these offshore managers have become big and integral to the investment decision-making process – a fact which should make them liable to Japanese tax laws. The offshore managers claim they are exempt from corporation tax because all of their trades are executed outside of Japan by an offshore counterparty so any fee income is exempt.
Under the new rules, however, an offshore manager with a research office in Tokyo of this kind must notify the FSA of their presence under article 63. And the concern among managers is that tax authorities will thereby claim the firms - and the funds they manage - have so-called “permanent establishment” in Japan, making them taxable.
If offshore managers operating large research operations in Japan are exposed to domestic Japanese tax rates, the implications for the Japanese hedge fund industry would clearly be catastrophic. So in a bizarre pre-emptive move, the FSA has requested the Finance Ministry – responsible for tax policy – spare offshore hedge funds from any crackdown on the tax status of foreign fund (although this request does not extend necessarily to the fund’s onshore managers).
In the absence of clarity about what form this exemption will take, and a detailed response from the Finance Ministry still to come, participants remain wary. Indeed, by ignoring the question of permanent establishment many in the industry feel that the new law represents a missed opportunity to provide the Japanese market with a real growth stimulus. “This is without doubt the main obstacle to the further development of the hedge fund industry in Japan, and FIEL has nothing to say on the matter,” said Andrew Hill, Director of Prime Finance Sales at NikkoCiti in Tokyo.
Kiyotaka Sasaki of the SESC has for some time been publicizing the risk posed by market manipulation and insider trading by hedge funds in Japan. He sees the new legislation as a useful step towards combating systemic risk. “FIEL puts in place a number of measures that will strengthen the market’s resilience to the type of manipulations that hedge funds have been creating,” he said.
But he was at pains to point out that the mushrooming worldwide industry had made enforcement of domestic legislation difficult. While regulation is an essential part of protecting the industry against hedge fund market abuse, effective policing relies equally on bilateral agreements between Japan, and the hedge fund centres of the US and UK, as well as the strengthening of powers of pan-national bodies like IOSCO.
An essential part of this will be the development of unitary supervisory regimes across the world. “Why, for example, are investment banks subject to the same supervision across territories, when hedge funds are not?” asked Sasaki. In Hong Kong, for example, regulator SFC will only concern itself with wrongdoing involving Hong Kong-listed stocks, meaning Hong Kong-based managers trading Japanese markets illegally will escape scrutiny, when hedge funds do not.
While regulators attempt to control under-regulated hedge funds through legislation like the FIEL, hedge funds continue to seek locations with low regulatory and tax burdens. Since the industry’s birth, the privacy of high net worth investors and institutions has been essential to a hedge fund’s success. In a global economy with increasingly internationalised and aggressive regulators, however, this feature of the hedge fund industry appears increasingly difficult to preserve.