What upcoming changes to Japan's FDI regime mean for non-Japanese investors

On March 14, 2020, the Japanese government released a summary of proposed changes to the regime created by the Foreign Exchange and Foreign Trade Act (the “FEFTA”), which subjects certain foreign direct investments in Japanese companies to a notification requirement and, in some cases, a waiting period, and proposed draft amended ordinances (the “Draft Ordinances”) under the FEFTA. The Draft Ordinances, after the solicitation of public comments, are proposed to be promulgated by the Japanese government under the authority of the FEFTA towards the end of May. This client alert provides necessary background to understand the Draft Ordinances and analyzes the content of the Draft Ordinances themselves.

Background

Japanese foreign direct investment restrictions drew notice in summer 2019  when 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 (the rules under the FEFTA as amended thereby, the “Amended Rules”) was a response to growing global concerns about national security and the leakage of critical technology. Then, in November 2019, amendments were made to FEFTA itself (the “FEFTA Amendment”) that, among other things, lower the threshold above which a foreign investor must submit a prior notification with respect to an investment in a Japanese listed company from 10% of outstanding shares or voting rights to 1%. The FEFTA Amendment is scheduled to be implemented no later than May 22, 2020, and the Draft Ordinances are expected to come into effect around the same time.

This increasingly strict notice and waiting-period regime under the FEFTA has met opposition from foreign investors. In particular, foreign investors in the venture capital space, where most companies are engaged in some variety of ICT-related business, raised concerns about the Amended Rules. Our experience indicates that, while foreign investors continue to have a strong interest in investing in the relatively untapped world of Japanese startups, the Amended Rules can be frustrating for venture capitalists accustomed to low-friction transactions and create unexpected costs and delays that force startups to wait longer for much-needed cash. On the other hand, opposition to the FEFTA Amendment has come primarily from those investing in listed companies, such as foreign financial institutions, hedge funds, sovereign wealth funds and activist investors.

The regime that governs foreign direct investments in Japan on the date of writing incorporates the changes made by the Amended Rules but not by the FEFTA Amendment or the Draft Ordinances. While the FEFTA Amendment is not yet in force, it has been passed and is in final form. The Draft Ordinances, by contrast, are still in draft form and may change before they are implemented. Under the FEFTA regime currently in effect, if, as the result of a transaction, a Foreign Investor (gaikoku toshika) directly or indirectly comes to hold 10% or more of the outstanding shares or voting rights of a Japanese company (taking into account any pre-existing holdings of such Foreign Investor), that Foreign Investor is generally required to submit an ex post facto (post-closing) report on the transaction to the Ministry of Finance (through the Bank of Japan) and any other relevant ministries by the 15th day (or, if the 15th day is a holiday, by the preceding business day) of the month following the month in which the transaction is consummated. On the other hand, if the Foreign Investor intends to make such a Foreign Direct Investment^[1] in a Japanese company and the company or its subsidiaries are engaged in a restricted business designated in the ordinances of the FEFTA (“Restricted Business”), prior notice must be filed with the Ministry of Finance and any other ministries relevant to the business in question (“Prior FDI Filing”). While this Prior FDI Filing requirement applies to acquisition of any shares in an unlisted Japanese company engaged in a Restricted Business (a summary of Restricted Businesses, as expanded in the Amended Rules, is given in this client alert), it currently applies to acquisition of shares in a listed company engaged in a Restricted Business only if such acquisition results in the Foreign Investor holding 10% or more of the outstanding shares or voting rights. 

Once the FEFTA Amendment enters into effect, the threshold for Prior FDI Filing requirement for Foreign Direct Investments in listed companies will fall from 10% to 1%, a change that has provoked a harsh backlash from foreign investors.

Draft Ordinances

The Draft Ordinances would, if implemented as currently drafted, would respond to many of the concerns of foreign investors by providing certain exemptions from the Prior FDI Filing requirement (“Prior Filing Exemptions”). However, it is important to note that, as the Japanese Ministry of Finance is now soliciting public comments with respect to these Draft Ordinances, they may change further before they come into effect in late May.

Exemptions for Foreign Direct Investments in Listed Companies

The Draft Ordinances would divide Foreign Investors into three categories to determine which Prior Filing Exemptions may apply to investments in listed Japanese companies: (i) foreign financial institutions, (ii) other foreign investors (including accredited sovereign wealth funds and public pension funds) and (iii) entities with a record of sanction or corrective order due to violation of the FEFTA or foreign state owned enterprises.

First, foreign financial institutions^[2] that are regulated and supervised in accordance with Japanese or equivalent foreign regulations (“Eligible Foreign Financial Institutions”) would be eligible for a blanket exemption if they satisfy all of the following conditions (the “Non-Managerial Involvement Conditions”):

• neither the Foreign Investor nor any “closely-related person” (missetsu kankeisha)^[3] serves as an officer (yakuin) of the listed company;
• the Foreign Investor may not make any proposal at any shareholders’ meeting with respect to the transfer or disposition of any business constituting a Restricted Business; and
• the Foreign Investor may not have access to non-public technical information pertaining to any Restricted Business.

An Eligible Foreign Financial Institution meeting all the Non-Managerial Involvement Conditions would be fully exempt from the Prior FDI Filing requirement with respect to investments into listed Japanese companies, regardless of whether that investment caused it to hold in excess of 1% or even 10% of the outstanding shares or voting rights of the company engaged in a Restricted Business. Even in light of the FEFTA Amendment’s lowering of the threshold to 1%, this would be a significant loosening of the current regime.

Second, where other Foreign Investors (including sovereign wealth funds and public pension funds accredited by the Japanese regulator^[4]) come to hold at least 1% of the outstanding shares or voting rights in a listed company engaged in a Restricted Business, the Draft Ordinances propose narrower exemptions, referred to by the government materials as the “General Exemption”. The General Exemption distinguishes between “core” and non-core Restricted Businesses. A Foreign Direct Investment into a non-core Restricted Business would not be subject to the Prior FDI filling requirement as long as the General Exemption applies (i.e., the Foreign Investor does not fall into the final category of Foreign Investors described below). With respect to an investment into a company conducting a Restricted Business identified as “core” (as described in greater detail below, a “Core Restricted Business”), a Foreign Direct Investment would be subject to the Prior FDI Filing requirement unless, in addition to all the Non-Managerial Involvement Conditions being met, the Foreign Direct Investment does not result in the Foreign Investor holding 10% or more of the outstanding shares or voting rights in such listed Japanese company and meets the following additional conditions (together with the Non-Managerial Involvement Conditions, the “Extended Non-Managerial Involvement Conditions”):

• the Foreign Investor does not participate in any committees with important decision-making authority with respect to projects in a Core Restricted Business; and
• the Foreign Investor refrains from submitting proposals in writing to the board of directors or equivalent body to request a response or action on a timely basis with regard to a Core Restricted Business.

Last, state-owned enterprises (other than accredited sovereign wealth and public pension funds) and Foreign Investors that have been sanctioned or subject to a corrective order due to violation of the FEFTA would never be exempt from the Prior FDI Filing requirements. Below is a chart summarizing various exemptions which might be available to Foreign Investors.

Exemptions for Foreign Direct Investments in Unlisted Companies

The Draft Ordinances would also loosen, to a degree, the Prior FDI Filing requirements for Foreign Direct Investments into non-listed companies. Under the Draft Ordinances and the FEFTA Amendment, the Prior FDI Filing requirement would not apply where the Foreign Direct Investment is made into a Non-Core Restricted Business, as long as the Non-Managerial Involvement Conditions are met. Under the current FEFTA, there is no such exemption.

Core Restricted Business

The Draft Ordinances would designate 24 businesses as Core Restricted Businesses. A summary of the businesses is provided in the chart below. It is worth noting that a wide range of telecommunications, cyber security and software businesses, when servicing certain other industries or when handling the personal information of no less than one million people, are categorized as Core Restricted Businesses, in addition to “traditional” restricted sectors such as weapons, aircraft, artificial satellites and the nuclear industry.

Scope of Restricted Business

The Draft Ordinances would create carveouts from certain ICT-related businesses that were designated Restricted Businesses by the Amended Rules, namely (i) custom development of software (Industry 3911), (ii) embedded software (Industry 3912), (iii) packaged software (Industry 3913), (iv) information processing (Industry 3921), and (v) internet use support (Industry 4013). While the Draft Ordinances seem to suggest that these businesses should not be considered Restricted Businesses as long as they are not in service of other Restricted Businesses, this will need to be clarified through the public comment process now taking place.

Other Amendments

Definition of Foreign Investor

Under the current FEFTA, a Foreign Investor is defined as any of the following: (i) an individual who is a non-resident of Japan; (ii) an entity established pursuant to a foreign law or having a principal office in a foreign country; (iii) a Japanese company in which the sum of (a) the voting rights held directly by persons as set forth in (i) and/or (ii) above, and (b) the voting rights held indirectly through a prescribed company of which the voting rights held by persons as set forth in (a) and/or (b) above is 50% or more of total voting rights; or (iv) a Japanese entity in which persons as set forth in (i) above constitute either a majority of all of the officers of the company or the majority of the officers having representative authority.

This definition does not currently refer to limited partnerships, so, in practice, it is necessary to determine whether each general partner and limited partner of the partnership, directly and individually, is considered a Foreign Investor. The FEFTA Amendment clarifies that a limited partnership will be a Foreign Investor if: (i) 50 per cent or more of the funds of the limited partnership are directly or indirectly contributed by Foreign Investors or (ii) the majority of the general partners of the limited partnership are Foreign Investors.

Corrective Order

The FEFTA Amendment provides more power to the regulator. Specifically, once it enters into effect, the regulator will have the power make corrective orders, including to rewind a transaction in case any Foreign Investor is found to be in breach of the Prior FDI Filing requirements (a “Corrective Order”).

Potential Impact on Various foreign Investors

Venture Capital and Corporate Venture Capital Investors

Because a large proportion of companies raising venture capital in Japan are engaged in ICT-related Restricted Businesses, many non-Japanese venture capital and corporate venture capital investors have been facing substantial delays in closing deals since the implementation of the Amended Rules. These investors are counting on the Draft Ordinances to facilitate the closing process through the application carve-outs in the ICT sector from the scope of the Restricted Businesses that are subject to the Prior FDI Filing requirement. Further, as long as these investors do not lead the financing round and receive board nomination rights, their investments in Non-Core Restricted Businesses will not be subject to the Prior FDI Filing requirement. In this regard, one practical question that needs to be clarified through the public comment process now taking place is whether having observer rights (as opposed to the board nomination rights) would comply with the Non-Managerial Involvement Conditions. On the other hand, the FEFTA Amendment and the Draft Ordinances still require both investors and companies to conduct careful diligence and drafting when it comes to the need for, and the content of any, Prior FDI Filing, because the consequences of failing to comply are made more severe by the possibility of a corrective order.

Institutional Investors Investing in Listed Companies

For most financial institutions, the FEFTA Amendment and the Draft Ordinances may not be as bad as they initially expected. As long as these institutions avoid being involved in the management of the companies they invest in, they will likely be exempt from the Prior FDI Filing. Further, after a long back-and-forth between regulators and foreign institutional investors, the Japanese regulator has proposed exemptions for certain sovereign wealth funds. On the other hand, the new regime may work against foreign activists and strategic investors contemplating eventual acquisition, because it is now likely that such investors will need to make a Prior FDI Filing at the 1% threshold. In this regard, the Japanese regulator announced that it plans to release at the end of April a list of which listed companies are engaging in Core Restricted Businesses, Non-Core Restricted Businesses and non-Restricted Businesses.

Conclusion

The revised foreign direct investment regime contemplated by the FEFTA Amendment and the Draft Ordinances tightens the current restrictions in some places and relaxes them in others. It will be important to follow how the public comment process for the Draft Ordinances develops and whether there are further amendments to them. According to a government website, they are planning to finalize and obtain approval from the Japanese Cabinet around the end of April. Further updates on the development of the Draft Ordinances will follow, but please feel free to contact us if you have any questions or comments.

^[1] The defined term “Foreign Direct Investments” covers various transactions and actions related to investment in a Japanese company by a Foreign Investor, including the acquisition of shares, consenting to making substantive changes to its business purpose or business matters that materially affect the company, establishment of a business office, making a loan/bond of a certain amount with a maturity exceeding one year, etc. Further, in the case of non-listed companies in Japan, any Specified Acquisitions (which captures acquisitions by Foreign Investors of shares in non-listed Japanese companies from other Foreign Investors, among other things) are subject to the equivalent Prior FDI Filing requirement.

^[2] This includes (i) securities firms, (ii) banks, (iii) insurance companies, (iv) asset management companies, (v) trust companies, (vi) registered corporate-type investment trusts and (vii) high-frequency traders, but, for high-frequency traders, only those who are registered with the Financial Services Agency are eligible for the blanket exemption. Other high-frequency traders are eligible for the general exemption.

^[3] The detailed scope of “closely-related persons” is provided in the Draft Ordinances.

^[4] State-owned enterprises are not, in principle, exempt from Prior FDI Filing, but the general exemption may apply to SWFs and public pension funds that pose no risk to national security if they are individually accredited by the Ministry of Finance. In performing such accreditation, the Ministry of Finance will review whether (i) the investment activities of the SWFs are for economic returns only and (ii) whether investment decisions by the SWFs are made independently of their governments. The results of such review will not be publicly announced.