On June 7, the amended ordinances (the “Amended Ordinances”) prepared by the Japanese government to implement amendments to the Foreign Exchange and Foreign Trade Act (the “FEFTA”) were fully implemented, after coming into effect on May 8, 2020.1 The amendments to the FEFTA (the “FEFTA Amendments”) were passed by the Japanese legislature in November 2019. In previous alerts, we summarized the exceptions created by the Amended Ordinances and the effects of the FEFTA Amendments (here and here).
This client alert highlights important considerations for international investors investing or planning to invest into unlisted companies in Japan, including startups.
The FEFTA and its regulations, among other things, impose certain restrictions on foreign direct investments made by foreign investors. Under the FEFTA, if a foreign investor makes a foreign direct investment under the circumstances described below, unless one of a limited number of exceptions applies, it needs to complete a prior filing, which subjects the transaction to substantive review by Japanese authorities. Other foreign direct investments that do not fall into such circumstances may require only a post-closing report, which does not involve substantive review.
Prior filing is generally required for a foreign direct investment by a foreign investor where (a) the nationality or the jurisdiction of the foreign investor is neither Japan nor a white-listed country; (b) the Japanese company into which the investment is made, or any of its Japanese subsidiaries or joint ventures in which it shares ownership equally, is engaged in a “restricted business” (a “Restricted Business”); or (c) certain transactions are to be made by Iran-related parties. Since most foreign investors do not have significant Iran-related business and are established in one of the 163 white-listed countries and regions, the prior filing requirement arising from investments into Restricted Businesses tends to be the most relevant. After submission, there is a 30-day waiting period before the foreign investor can consummate the transaction. This period is often shortened to two weeks but may be extended to up to five months if any relevant ministry decides that it needs more time to complete its review.
In mid-2019, the FEFTA regime was expanded to require prior notification with respect to investments in Japanese companies in certain information and communications technology (ICT)-related businesses (see our client alert here). Like the United States’ Foreign Investment Risk Review Modernization Act of 2018 (FIRRMA), which expanded the jurisdiction of the Committee on Foreign Investment in the United States (CFIUS), and the European Union’s 2019 Framework Regulation for the screening of foreign investments, this amendment to the FEFTA rules was a response to growing global concerns about national security and the leakage of critical technology. However, this change became very unpopular in the venture communities in Japan, because many startups in Japan, which, like anywhere else in the world, are at least somewhat engaged in ICT-related businesses, became subject to a regime that required any foreign investor acquiring even one share from that startup to make a prior notification and comply with the waiting period and potential requests for information from authorities.2
The Amended Ordinances, together the FEFTA Amendments, now fully implemented, are the most recent step in the evolution of the FEFTA regime. While there are other amendments that affect investments into unlisted companies in Japan under the Amended Ordinances, such as the definition of “Foreign Investor,” this alert focuses on the two most significant changes that relate to investments into unlisted companies. One is the expansion of the scope of non-investment actions that trigger an obligation of prior notification, and the other is the scope of available exemptions to the requirement to make a prior notification, as discussed in detail below.
In addition to foreign direct investments into Japanese companies, which have been the primary subject of the FEFTA, any vote by a foreign investor holding no less than one-third of the voting rights of a Japanese company in favor of the amendment of the business purpose of such company was subject to a prior notification requirement. Further, following the implementation of the Amended Ordinances, the scope of non-investment actions subject to prior filing requirements is expanded to include the following actions (collectively, “Restricted Actions”) taken by foreign investors with respect to Japanese companies that are engaged in Restricted Businesses:
In general, under the FEFTA, if a Japanese company into which a foreign investor intends to make a foreign direct investment is engaged in a Restricted Business (see this client alert for a list of Restricted Businesses), the foreign investor is required to file a prior notification unless a prior filing exemption applies. It should also be noted that the prior filing exemptions in general apply only to exempt certain foreign direct investments and do not exempt foreign investors from the obligation of prior notification with respect to any of the Restricted Actions described above.
The Amended Ordinances create a set of new exemptions for investments into listed Japanese companies, but for unlisted Japanese companies, the only potentially applicable prior filing exemption is what is known as the “General Exemption”. In order for this prior filing exemption for investments in unlisted companies to apply, three major criteria must be met: first, such foreign investor must not have a record of sanction or corrective order due to violation of the FEFTA or be a foreign state-owned enterprise or similar entity (other than for sovereign wealth funds and public pension funds accredited by the Japanese Minister of Finance), second, the unlisted Japanese company into which the investment is made must not be engaged in a “core” Restricted Business, and, third, certain “non-managerial involvement conditions” must be satisfied.
Core Restricted Businesses. From among the many categories of business designated “restricted” under the FEFTA regime, the Amended Ordinances identify a separate group of special importance, referred to as “core” Restricted Business. For a summary of the businesses included in this category, please see our client alert dated March 27, 2020. In order for the General Exemption to apply, the unlisted Japanese company into which the foreign investor intends to invest must not be engaged in a core Restricted Business (i.e., the Restricted Business in which it is engaged will be one of the non-core Restricted Businesses).
Non-Managerial Involvement Conditions. To satisfy the non-managerial involvement conditions, neither the foreign investor nor any “closely-related person”5 of the foreign investor may serve as a director (torishimariyaku) or a statutory auditor (kansayaku) of the issuer. In addition, a foreign investor must not make any proposal, itself or through other shareholders, at any shareholders’ meeting of the issuer, with respect to the transfer or abolishment of any business constituting a Restricted Business. Further, a foreign investor must not have access to non-public technical information pertaining to any Restricted Business of the issuer. According to an answer from the Ministry of Finance in the public comment procedure, the definition of "non-public technical information” is to be interpreted in accordance with the definition of “trade secret” under the Unfair Competition Prevention Act of Japan. Information about the employment terms and compensation of officers, etc., and financial information of the issuer, could not be considered “non-public technical information”. Also, if such information is provided voluntarily by the issuer to the foreign investor, it could not be considered non-public technical information. However, if such information is provided through the application of the foreign investor’s influence based on its shareholding or voting rights, the information could not be considered to be provided voluntarily by the issuer.
Further, it should be noted that after a foreign investor’s acquisition of shares in reliance on a prior filing exemption, if, for instance, the following changes are made to the attributes of a foreign investor, a post-closing report is required:
Finally, even when investing in a Japanese company that is not engaged in a Restricted Business, or when using a prior filing exemption to invest in a company conducting a Restricted Business, a foreign investor is still required to file a post-closing report following the consummation of the investment.
1. Think Ahead
Both Japan-based startups and non-Japanese investors should address at the very beginning of term sheet discussions whether the investment by such investor would be subject to the prior filing requirement under the FEFTA and, if so, whether to seek an available exemption. In this regard, while the Japanese government publishes the list of all listed companies in Japan to categorize whether they are conducting Restricted Businesses or core Restricted Businesses, such a database is not available for unlisted companies. As such, a careful examination by startups themselves and consultation with their counsel, as well as the Bank of Japan, should be conducted.
This exercise is critical, because it could potentially materially delay the timing of closing due to the 30-day waiting period after the filing (subject to shortening or extension of such period) as discussed above.
2. Drafting of Investment Agreements
From the foreign investor’s side, not only should the clearance of the prior filing process pursuant to the FEFTA be a condition to closing (if it is necessary to make such a prior filing), but they should also request that companies provide in a purchase agreement or similar document proper representations and warranties as to the categories of business that the company is engaged in, in order to enable the foreign investor to analyse and decide whether or not to make a prior filing.
Further, if an investor is relying on the “General Exemption”, because acquisitions of equity interests for the purpose of violating the non-managerial involvement conditions are not eligible for prior filing exemptions, caution should be exercised if the right to appoint directors or the right to receive certain information is provided for in the investment agreements.
3. Observer vs Director
Since any affirmative vote by a foreign investor with respect to a proposal to elect such foreign investor, or a closely related person of such foreign investor, as a director is one of the Restricted Actions, it is likely that exercise by a foreign investor of board nomination rights with respect to a Japanese company engaged in a Restricted Business pursuant to the articles of incorporation or a shareholders agreement now requires prior filing. According to an answer from the Ministry of Finance given through the public comment procedure, whether or not such foreign investor in fact has a right to appoint specific nominee directors can be broadly interpreted, so startups may prefer giving an observer right instead, to avoid such prior filing requirement.
4. Watch Out for Issues with Exit Path
Both Japan-based startups and non-Japanese investors should also note that prior filing requirements for the Restricted Actions could potentially affect their exit path, because any affirmative vote by the foreign investor with respect to a proposal for an M&A exit, including business transfer (jigyou jouto), merger, company split (kaisha bunkatsu) or similar transaction, could be considered a Restricted Action.
According to an answer from the Ministry of Finance given through the public comment procedure, it is generally understood that any affirmative vote referred to here is limited to votes at the shareholders meeting in which the proposal was made by the relevant foreign investor itself or through other shareholders. As such, generally speaking, the exercise of consent rights under protective provisions of the shareholders agreement should not be considered a Restricted Action. However, this is more of a facts-and-circumstances test, so careful review should be conducted for each transaction.
While the prior filing exemptions introduced by the Amended Ordinances go some way toward easing the regulatory burden on foreign investors in listed Japanese companies, the environment for private equity and venture capital is less forgiving. In particular, foreign investors will likely find it difficult to lead venture capital financings without triggering prior filing obligations unless they are willing to forego the customary board seat and certain information rights. The added requirement of prior filing before taking the Restricted Actions described above further restricts the involvement of foreign investors in the governance of the Japanese companies they invest in.
As a result, those looking to invest in unlisted Japanese companies should determine at an early stage whether they are engaged in a Restricted Business. If so, budget additional time and money not only for the filling itself but for how this filing can complicate the transaction itself. For example, financings that would normally be signed and consummated simultaneously may have to be reworked to include an interim period to allow for the waiting period after prior filing.
1 This “full implementation” means that, while the Amended Ordinances have been in force since May 8, June 7 represents to date on and after which Japanese authorities will actually apply them.
2 There is no de minimis threshold to trigger prior notification requirements with respect to investments into unlisted companies by foreign investors. By contrast, foreign investors in listed companies are only subject to this requirement if, as a result of the investment, they hold at least 1% of the listed company post-closing (this was lowered from 10% by the FEFTA Amendment).
3 The scope of “closely related person” differs depending on whether such proposals are made by a foreign investor itself or through a third party asked by such foreign investor, or by a third party itself (the scope is wider in the former case).
4 Or, when a proxy pertaining to voting rights in a listed Japanese company is granted to a foreign investor by persons other than other foreign investors, where there is 10% or more (including the percentage of the voting rights held by a closely related person) of the voting rights of the investee company.
5 The definition of “closely-related person” differs depending on whether the proposal in question is made by the foreign investor itself or through a third party asked by such foreign investor, or by a third party itself (the definition is wider in the former case).