The Structured Products Law Review: Japan
The Japanese structured products market has a long history and is still active, although no official statistics are available. For retail investors, running a search on EDINET,2 the Japanese equivalent to the US EDGAR, will find many derivatives-embedded securities linked to exposure to Nikkei Stock Average (Nikkei 225) and FX transactions. According to one publicly available source, the outstanding amount of Nikkei 225 linked public-offered bonds appeared to be around ¥900 billion in November 2020. Banks also offer structured deposits to retail customers. Further, on the institutional investor front, similar or more complex types of structured products linked to stock indices and FX transactions, such as power reverse dual bonds, reverse floater bonds and constant maturity swap bonds, are offered.
The structured products described above are typically issued by foreign financial institutions (including foreign subsidiaries of Japanese financial institutions) pursuant to foreign laws and offered to investors in Japan. The structure of trust bonds established pursuant to Japanese law is also seen (as discussed further in Section II). Additionally, we understand that offshore vehicles are utilised to issue structured bonds.
For public offerings (typically sold to retail investors), securities registration statements are filed (see Section III). Domestic and foreign bonds fall under the definition of securities under Article 2, Paragraph 1 of the Financial Instruments and Exchange Act of Japan (FIEA) (Paragraph 1 securities). If this is the case, a financial instruments business operator that conducts a Type I business registered pursuant to the FIEA (Type I business operator) generally distributes bonds to investors.
Legal and regulatory framework
i Types of structure
Japanese structured products (issuing bonds3) are differentiated into two types.
Under one typical structure, a going-concern issuer such as a foreign financial institution issues bonds whose terms and conditions already have derivatives features embedded (issuer bonds). The issuer will enter into back-to-back derivatives transactions with a dealer for hedging purposes. The issuer bonds are typically governed by the foreign law where the issuer is located; for example, if the issuer is located in the UK, English law governs.
Under another typical structure, an arranger sets up a bankruptcy-remote special purpose vehicle (SPV), and that SPV issues bonds to investors and enters into derivatives transactions with a swap counterparty (SPV bonds). In Japan, trusts under the Trust Act of Japan (Trust Act) are utilised as vehicles for issuing bonds, in addition to SPVs established offshore, such as in the Cayman Islands, issuing bonds pursuant to foreign laws such as English law. For SPV bonds, the issue amount from investors will be invested in a safe underlying asset such as Japanese government bonds. For the purpose of matching cashflows between the SPV bonds and the underlying assets, derivatives transactions are used and the swap counterparty provides cashflow tailored to payments of the principal and interest of the SPV bonds.
From a credit risk perspective, investors in issuer bonds are subject to the credit risk of the issuer. However, investors in SPV bonds are subject to the credit risks of both the swap counterparty and the issuer of the underlying bonds.
ii Trust bonds
As the trust structure is Japan-specific, we would like to elaborate on trust bonds as follows. Under the Companies Act of Japan (the Companies Act), a trust bond is defined as 'a bond that the trustee of a trust issues, which is issued for trust property (meaning the trust property established in Article 2, Paragraph 3 of the Trust Act)' (Article 2, Paragraph 3, Item 17 of the Regulation for Enforcement of the Companies Act).
An issuer of trust bonds is typically a trust bank. An arranger (as trustor) and a trust bank (as trustee) enter into a trust agreement. The initial trust property paid by the arranger is nominal cash. The trust bank issues trust bonds for the trust property, and the issue amount of the trust bonds comprises the trust properties under the trust agreement. The issue amount will be invested in a safe underlying asset such as Japanese government bonds, and the trust bank also enters into a swap agreement with the arranger to generate cash flow of the interest and principal of the trust bond linked to, for instance, a stock index. Issuance of the trust bonds is based on limited recourse clauses so that the obligations of the trust bank (issuer) are limited to the trust property of the trust bonds only. To protect the structure, there is also a prohibition against filing for the commencement of bankruptcy proceedings for the trust property stipulated in the trust agreement.
Pursuant to Article 25, Paragraphs 1, 4 and 7 of the Trust Act, even where a trust bank is subject to bankruptcy, rehabilitation or reorganisation proceedings, the trust property will not be subject to such proceedings. In other words, the trust property is independent from the credit risk of the trust bank so long as the trust bank complies with its legal obligations as a trustee. Thus, investors in trust bonds are limited to the credit risks of both the swap counterparty and the issuer of the underlying bonds.
Issuance of trust bonds is subject to the Companies Act. The trust bond is treated as a corporate bond under Article 2, Paragraph 1, Item 5 of the FIEA. Thus, disclosure of the publicly offered trust bond is subject to the statutory process pursuant to the FIEA, the relevant enforcement order and cabinet office ordinances. It is possible that the Act on Book-Entry Transfer of Corporate Bonds and Shares of Japan will apply to trust bonds, whereby the trust bonds are handled by the book-entry transfer system operated by the Japan Securities Depository Center, Incorporated.4
iii Japanese law applications and the regulator
Laws and regulations applicable to distributions of structured products
When Type I business operators distribute structured products that are Paragraph 1 securities to investors, the applicability of the FIEA has to be considered from several perspectives. The supervisory body for Type I business operators is the Financial Services Agency of Japan (JFSA). The FIEA stipulates numerous regulations applicable to distributions of structured products, including, without limitation:
- a duty of sincerity to customers (Article 36);
- regulation of advertising (Article 37);
- delivery of documents both prior to the conclusion of a contract and upon the conclusion of a contract (Articles 37-3 and 37-4);
- an obligation to conclude a contract with a designated dispute resolution organisation (Article 37-7);
- prohibited acts (Article 38);
- a prohibition on compensation of loss (Article 39); and
- the principle of suitability (Article 40).
However, some of these regulations are exempt if customers are classified as professional investors. Professional investors include qualified institutional investors (such as banks and insurance companies), the state and the Bank of Japan (BoJ). Listed companies and stock companies whose stated capital is expected to be ¥500 million or more are also included, but they can be treated as non-professional investors if they would like to be so by applying the statutory procedures. Conversely, corporations that are originally classified as non-professional investors as well as certain high net worth individuals can be treated as professional investors if they would like to be so by applying the statutory procedures.
The Act on Sales, etc., of Financial Instruments of Japan (Sales Act)5 also provides investor protection mechanisms by forcing financial instruments providers, including Type I business operators, to explain statutorily important matters to customers. Important matters under the Sales Act include a risk of principal losses, indicators that lead to principal losses due to fluctuations and important portions of the structure of transactions. Financial instruments providers are also prohibited from providing customers with conclusive evaluations on uncertain matters or with information that misleads them into believing that uncertain matters are certain. If financial instruments providers fail to comply with the above obligations, the Sales Act stipulates clauses concerning liability for damages and presumptions concerning the amount of loss that provide customers with easier damage claims as compared with those under tort pursuant to the Civil Code of Japan. An explanation of the important matters pursuant to the Sales Act will not be necessary if customers are specified customers that overlap with professional investors as stipulated under the FIEA, or if the customers have manifestly expressed that they do not require such an explanation.
Laws and regulations applicable to structured deposits
Structured deposits offered by banks are regulated by the Banking Act of Japan (Banking Act). The Banking Act stipulates that structured deposits are specified deposits. Specified deposits are defined as 'deposits or instalment savings, etc., that carry the risk of a loss of the principal due to fluctuations in the money rate, value of currencies, quotations on a financial instruments market as prescribed in Article 2, Paragraph 14 of the FIEA, or any other index', and more precise specifications are provided by the delegated Regulation for Enforcement of the Banking Act. The following fall under specified deposits:
- deposits that require that a penalty be paid or other conditions equivalent to this when a depositor terminates the deposit before maturity, and that the amount, as a result of deducting the amount of said penalty from the balance of said deposit at the time of said termination, is likely to fall below the deposited amount due to changes in money rates, values of currencies, quotations on a financial instruments market and other indexes;
- deposits that are indicated in a foreign currency; and
- deposits for which a currency option transaction is incidental.
The investor protection mechanism under the FIEA described above in addition to the termination of contracts during a statutory cooling-off period generally apply mutatis mutandis to a bank's conclusion of contracts for specified deposits. The Sales Act described above is also applicable.
iv Margin requirements for non-centrally cleared derivatives
The Basel Committee on Banking Supervision and International Organization of Securities Commissions' margin requirements for non-centrally cleared derivatives have been implemented in Japan since September 2016 via the two separate channels of the FIEA and the supervisory guidelines of the JFSA (collectively, the Japanese MR). Under the Japanese MR, a trust formed by a trust bank (as a trustee) that is a registered financial institution under the FIEA is subject to the Japanese MR if certain conditions are met, such as that a swap counterparty is also a financial instruments business operator or a registered financial institution,6 and that the swap agreement is a non-cleared over-the-counter (OTC) derivatives transaction for FIEA purposes. The JFSA's response to consultations concerning the relevant draft regulations (public comments) mentions that even if a trust account is used as a repackaged vehicle, no special exemption is scheduled to be implemented.7 Generally, even in a trust bond structure, depending on the swap exposure, the trust bank posts underlying assets to the swap counterparty (and receives collateral from the swap counterparty) as a variation margin.
When responding to the question about derivatives transactions embedded in deposits or loans, however, the JFSA has responded that the Japanese MR will not be applicable if OTC derivatives transactions are integrated with deposits or loans, which are the major factors in transactions.8
Offering process and post-sale requirements
i What is a public offering?
In general, an offering by an offshore issuer of newly issued debt securities in Japan is treated as a public offering under the FIEA if the number of offerees (excluding certain qualified institutional investors) in Japan is 50 or more.9 Thus, an offering of structured products that targets retail investors in Japan would constitute a public offering, and private deals targeted at professional investors only or a small number of investors could rely on private placement exemptions.
There have been no significant amendments of the relevant securities laws in recent years. As such, a general overview of public offerings and private placements of debt securities is provided in Sections III.ii and III.iii.
ii Public offering process
In the case of a public offering of newly issued debt securities, if the aggregate offer price in the proposed offering in Japan is ¥100 million or more,10 the issuer must file a securities registration statement (SRS) with the Director General of the Kanto Local Finance Bureau with respect to the proposed offering in Japan.11 The SRS must include comprehensive information regarding the offered securities and the issuer (e.g., an SRS for trust bonds must contain the structure of the trust, the status of underlying assets, risk factors, financial information of both trustor and trustee, and similar information). The SRS will be publicly disclosed on EDINET. As a general rule, the SRS will become effective 16 days after it is filed, and the issuer cannot start offering until then. When the issuer is subject to continuous disclosure requirements under the FIEA (i.e., the issuer made public offerings in Japan in the past), the waiting period for the SRS can be shortened to approximately seven days. In addition, such issuer can file a shelf registration statement instead of an SRS to achieve a more flexible offering through the shelf registration system.
The issuer in a public offering must deliver a prospectus to each offeree with respect to the proposed offering in Japan. The prospectus must contain certain items regarding offered securities and the issuer in accordance with the FIEA. In practice, because most debt securities are sold through OTC transactions, securities companies as distributors for offered securities deliver a prospectus to potential investors.
iii Private placement process
In cases where issuers rely on the private placement exemptions discussed in Subsection i, there are no filing requirements under the FIEA. However, issuers must notify offerees that no SRS has been filed in relation to the private placements. Delivery of a prospectus is not a requirement under the FIEA for a private placement but, in practice, issuers prepare a prospectus in concert with arrangers and deliver it to investors even when the products being offered in the private placement are tailored for a single investor. This is because the FIEA requires that Type I business operators as distributors deliver certain documents to their clients prior to and upon the conclusion of a sale and purchase agreement for securities (see Section II.iii).
iv Investor identification
Under the Act on Prevention of Transfer of Criminal Proceeds of Japan (APTCP), a financial institution, including a bank or a securities company, is required to identify and verify its customers when conducting individual transactions with them. In principle, customer identification documents, the purpose for conducting the transaction and other information is necessary to identify and verify a customer.
The identification and verification methods, and the necessary documents to be obtained from customers, are specified in the relevant ordinance of the APTCP. Previously, face-to-face know your customer (KYC) procedures through the presentation of identification documents and non-face-to-face KYC procedures through postal mail with no-forwarding service were used in practice. However, since 30 November 2018, online-based procedures involving the provision of a photo or video of customer identification documents (called 'eKYC') are permitted as an additional KYC method. Recently eKYC has become more important for financial institutions in order to continue ordinary business during the covid-19 pandemic. On 28 May 2021, the JFSA published the Q&As on eKYC12 for financial institutions that plan to introduce eKYC. As the JFSA encourages eKYC, with a view towards enhancing the digital transformation of the financial industry, eKYC will be used more widely in the near future.
Financial institutions must also check, inter alia, their customers' knowledge, investment experience, risk appetite, investment purpose and asset portfolio, and ensure that the offered products are suitable for those customers. In fact, a lot of litigation and alternative dispute resolutions in relation to complex structured products (especially sales of derivative embedded debt securities to retail investors without suitability checks or adequate explanations) have occurred in Japan during the past decade. Such suitability checks are necessary to mitigate post-sale liability of distributors.
Exchange listing and trading
In Japan, most structured products are not listed on exchanges and are traded via securities companies as OTC transactions. The trade volume of such OTC structured products in the secondary market is relatively low.
The only category of listed structured products on Japanese exchanges is exchange-traded notes (ETNs) that intend to track the performance of various underlying indices. In 2011, the listing rules of the Tokyo Stock Exchange (TSE) for ETNs were established, and trades of listed ETNs on the TSE began. By the end of 2019, all ETNs listed on the TSE were issued by non-Japanese issuers. In accordance with the practice in the Japanese market, these ETNs are in the form of Japanese depositary receipts issued pursuant to the Trust Act, and their underlying assets are derivative embedded notes governed by non-Japanese laws. However, after the TSE listing rules for ETNs were amended on December 2019, ETNs issued outside Japan by Japanese financial institutions also became eligible for listing. As of July 2021, 24 ETNs issued by non-Japanese issuers and three ETNs issued by a Japanese financial institution are listed on the TSE.
i Taxation for Japanese investors
Typical structured products in the form of debt securities are generally treated as bonds for Japanese tax purposes. Any interest on bonds and gains derived from the sale or redemption of bonds that are receivable by individual residents of Japan and Japanese corporations are generally subject to Japanese taxation, as is the case with straight bonds.
For individual residents of Japan, taxable income in relation to bonds is taxed separately from other types of income, such as business income and salary income. The applicable tax rate is, in general, 20.315 per cent (including a 5 per cent local tax and 0.315 per cent special surtaxes). When an issuer or a paying agent located in Japan makes a payment of interest on bonds, 20.315 per cent of the interest amount is withheld. Proceeds from a sale of bonds and payment of principal (except the principal of certain discounted bonds and strip bonds) are not subject to withholding tax, so in general individual residents of Japan must file a tax return with the relevant regional taxation office with respect to gains derived from a sale or redemption of bonds.
For Japanese corporations, all income and losses are aggregated for the purpose of corporate taxation. Applicable tax rates are slightly different depending on the amount of capital and location, but the effective tax rate for Japanese corporations is approximately 29.74 per cent. However, a 15.315 per cent withholding tax is withheld on the payment of interest made by an issuer or a paying agent located in Japan.
Interest on structured deposits is also taxed and withheld at the same rate for interest on bonds.
ii Tax ruling
There is no official tax clearance or ruling system from the National Tax Agency, the tax authority in Japan. However, when taxation issues arise during a structuring process and no clear interpretation has been revealed by the authority, issuers or arrangers of structured products may submit an enquiry before a transaction to request a written response from the National Tax Agency about whether they will be subject to taxes. This advance enquiry functions in practice as a tax clearance in other countries. In addition, issuers and arrangers can also obtain informal guidance on the tax treatment of a particular transaction through informal consultation with tax officers at regional taxation bureaus or tax offices. This informal guidance may provide some comfort to proceed with a transaction.
iii Recent amendments to tax legislation
On 1 January 2016, amendments to financial instruments taxation laws became effective in order to reduce the imbalance of income tax treatments on individual residents among various financial instruments. The goal of the amendments is to achieve simpler taxation and encourage investments in securities by individual investors. The amendments enable losses on the sale of listed equity securities or publicly offered bonds to be deducted against interest on publicly offered bonds and gains derived from the sale or redemption of publicly offered bonds, and at the same time enable losses on the sale of non-listed equity securities or privately offered bonds to be deducted against interest on privately offered bonds and gains derived from the sale or redemption of privately offered bonds. After the amendments described above, there have been no material amendments to tax legislation that generally affect tax treatment of structured products.
i Regulations of the self-regulatory body
In relation to complex products similar to OTC derivatives transactions, the Japan Securities Dealers Association (JSDA), a self-regulatory body of brokers and dealers in Japan, introduced self-regulatory regulations in April 2011 that apply to members of the JSDA.
The regulations require that:
- before distributing products to customers, members verify reasonable grounds concerning the suitability of products, such as risk profiles and performance, and establish solicitation criteria for selecting customers by considering their age, whether they have previous experience with the type of transaction and the assets that the customers hold; and
- members enhance their obligations to explain when soliciting and selling products by:
- delivering explanatory documents, including warnings of risks inherent in products, and the contact information for the institution for financial alternative dispute resolutions;
- providing explanations about material matters such as losses in worst-case scenarios, selling restrictions and preliminary calculations of the selling amounts during the term of a transaction; and
- receiving confirmation letters from customers.
The JSDA explains that in general, the regulations cover exchangeable bonds, equity indices-linked notes and dual currency bonds with conditions.
ii Impacts of the LIBOR transition
The response in Japan to the discontinuation of the London Interbank Offered Rate (LIBOR) involved the establishment of the Cross-Industry Committee on Japanese Yen Interest Rate Benchmarks13 (secretariat: the BoJ) in August 2018. At the time of writing, the transition plan for JPY LIBOR published as of the end of March 2021 is the most recent version.14 For JPY LIBOR, on 5 March 2021, ICE Benchmark Administration Limited (IBA) and the UK Financial Conduct Authority (UKFCA) issued publications on future cessation of LIBOR. According to the publications, there will be two paths for the future of JPY LIBOR as follows:
- spot-next, one-week, two- and 12-month JPY LIBOR settings: permanent cessation after the end of 2021; and
- one-, three- and six-month JPY LIBOR settings: non-representativeness after the end of 2021, but they are scheduled to continue until the end of 2022, one additional year, on a 'synthetic' basis based on the UKFCA's exercise of a proposed new power.
Against the backdrop of the separate but closely linked publications by the IBA and the UKFCA, the JFSA and the BoJ made public their joint statement on 8 March 2021. The joint statement states:
- synthetic JPY LIBOR, even if implemented, should not be used in new contracts and transactions since '[i]t is of utmost importance to steadily reduce the amount of contracts referencing JPY LIBOR to advance orderly transition away from JPY LIBOR'; and
- 'synthetic JPY LIBOR should be considered a potential “safety net” and used only for legacy contracts that cannot feasibly be transitioned away from JPY LIBOR after proceeding thoroughly with actions'. Further, '[i]t should also be noted that the [UK]FCA's proposal is to limit the publication period of synthetic JPY LIBOR to one year'.
In Reforming Major Interest Rate Benchmarks,15 the Financial Stability Board advocated a multiple-rate approach under which different appropriate interest rate benchmarks are used depending on the financial instruments or the nature of transactions. This is to be accomplished by enhancing the reliability and robustness of existing interbank offered rates (IBORs), such as the LIBOR and Tokyo Interbank Offered Rate (TIBOR), and identifying a nearly risk-free rate (RFR) that should not reflect the credit risks of banks; the assumption is that IBORs would be used for, inter alia, loans, and RFRs would be used in many derivatives transactions.
In Japan, the TIBOR reform was implemented by the JBA TIBOR Administration, and a Tokyo Overnight Average Rate (TONA) was selected to serve as an RFR. Further, Tokyo Term Risk Free Rate (TORF), a forward-looking term RFR, was officially launched on 26 April 2021.16 It is difficult to assess which of the three rates (i.e., TIBOR, compounded TONA and TORF) will lead the structured product market in Japan, but market participants for structured products referencing JPY LIBOR should monitor the progress of transition and contractual fallback rates in the market closely.
Outlook and conclusions
As can be seen from the above, the Japanese structured products market is stable and well developed from many perspectives such as the market's size, varieties of products, including Japan-specific trust structures, and healthy and enhanced laws and regulations to protect (retail) investors. Market participants from the buy-side as well as the sell-side appear to be very familiar with this asset class. The outlook for the market should be stable, and we believe that market participants can continue to handle new issues such as market turmoil due to the covid-19 pandemic and the LIBOR transition in an appropriate manner going forward.
1 Naoya Ariyoshi and Yuki Taguchi are partners and Toshiyuki Yamamoto is counsel at Nishimura & Asahi.
3 We understand that structured loans, whose economics are similar to structured bonds, are also popular products in Japan.
5 The Sales Act was renamed the Act on Provision of Financial Services in order to introduce a new regulatory framework for one-stop financial service intermediaries. The new Act will be implemented on 1 November 2021. However, the investor protection mechanisms described in this article remain in the new Act.
6 As to a foreign swap counterparty, 'a person engaged in OTC derivatives transactions in the course of trade in a foreign state' is subject to the Japanese MR. Thus, in general, foreign financial institutions serving as swap counterparties are subject to the Japanese MR. However, note that foreign states here are limited to those where close-out netting or any similar clauses are appropriately confirmed to be effective in light of laws and regulations of such foreign states.
7 See No. 41 on page 7 available at https://www.fsa.go.jp/news/27/syouken/20151211-1/01.pdf (Japanese only).
8 See No. 7 on page 2 available at https://www.fsa.go.jp/news/27/syouken/20160331-4/01.pdf (Japanese only).
9 However, in cases where structured products are created in the form of trust beneficiary interests without beneficiary certificates, the offering of such newly issued structured products (i.e., an offering of securities other than Paragraph 1 securities) is treated as a public offering if the number of parties acquiring such interests (excluding certain qualified institutional investors) in Japan is 500 or more.
10 If the same kind of debt securities (i.e., securities with the same maturity, coupon and currency) was offered in Japan during the past year, the aggregate offer price in the past offering is also counted for the purpose of the ¥100 million threshold, although it is unlikely to occur in the context of debt securities.
11 If the amount ranges from ¥10 million to ¥100 million, the issuer must file a securities notice with the Director General of the Kanto Local Finance Bureau, which is simpler than an SRS and is not publicly disclosed.
12 https://www.fsa.go.jp/common/law/guide/kakunin-qa.html (Japanese only).
15 https://www.fsb.org/wp-content/uploads/r_140722.pdf (published in July 2014).