The following article originally appeared in AsianInvestor magazine, March 2007. This is an abbreviated version.

Can JapanÆs new securities and investment law create a healthy and flexible regulatory environment in line with international norms, or add red tape to an already unfriendly tax regime that will prompt more hedge funds to flee to Singapore, Hong Kong or other jurisdictions?

JapanÆs bureaucrats are near completion on a sweeping legislative reform of financial regulation. This is a much-needed modernisation and streamlining of the current mishmash of laws governing all aspects of the industry, but particularly asset management. All fund managers, both onshore and offshore, will be affected, but probably none more than hedge funds.

In general, the Financial Instruments and Exchange Law (FIEL) is a welcome development that should put Japan in line with international norms by emphasising consumer protection and innovation, replacing a raft of proscriptive measures and redundant laws.

ôThe FIEL culminates a decade of legal deregulation,ö says Jonathan Schuman, legal counsellor at AIG in Tokyo. ôLaws traditionally kept different functions in silos. There were separate laws for investment trust and investment advice. Now financial service providers can become a one-stop shop.ö

But the devil is in the details, and the details have yet to be determined. Moreover, the law will close loopholes that many fund managers have exploited. Many offshore funds will now come under regulation and hedge funds will be required to register with the Financial Services Agency. The FIEL promises a more flexible environment, but one that is also designed to be more easily scrutinised by the authorities.

ôNon-Japanese investment advisors with a research office here will still have to register,ö says Naohiko Matsui, general counsel and director at the FSA. He tells AsianInvestor that the government decided to overhaul financial regulation following the collapse of a fund in 2005 that had exploited omissions in the commercial law to solicit to Japanese investors without needing authorisation from the FSA.

The upshot is that hedge funds will now come under increased regulation, albeit within a much-improved environment.

ôThe FSAÆs new rules for distribution arrangements is a stunning change,ö says Christopher Wells, partner at White & Case in Tokyo. He notes that this is in line with a desire among global regulators to scrutinise the industry; AmericaÆs Securities and Exchange Commission tried to require hedge funds with US citizens as clients to register, although the move was thrown out in court. But hedge funds are now being put on the agenda of the next G7-governments meeting in Germany and remain a topic of interest among central banks and regulators across the world.

Nonetheless the FIEL is a bold move at a time when other centres in Asia, notably Singapore and Hong Kong, have attracted hedge funds with the lightest of regulatory touches. Japan, in the meantime, seems to have sent discouraging signals to the industry, with its pursuit of Yoshiaki MurakamiÆs fund which tried to decamp to Singapore, as well as a burdensome tax regime (which is outside of the FSAÆs or the FIELÆs control).

ôWe realise that some hedge funds will criticise our decision to have them register,ö Matsuo says. ôWe acknowledge there are fears that some hedge funds will leave Japan. But we are not interested in a race to the bottom. This is a race for quality. The new law will make it easier for hedge funds. We want them here.ö

He points out that while hedge funds must register with the FSA, the regulator cannot hold up an application that meets all the criteria. Under existing laws, the FSA has some discretion regarding approving certain investment products. If it was uncertain about a new fund, it could stretch out approval times. ôNow we wonÆt be able to say no,ö Matsuo says.

There are other important new measures in the FIEL. One is the requirement to disclose shareholdings of 5% or more in Japan-listed companies within five business days. Before, investment advisors only had to report these every quarter. The new rule is designed to thwart a firmÆs multiple funds from combining trades to become de facto big shareholders, and reflects the governmentÆs unease regarding foreign takeovers. It will create costs for international investment firms.

A final question mark concerns self-regulatory organisations (SROs), which play an important role in Japan in setting and interpreting rules, and carrying out inspections. Currently the SROs are separated, in line with the old set of laws. The Japan Securities Dealer Association looks after brokers, while asset management has two SROs, one for investment advisors and one for investment trust managers.

The FIEL is silent on the role of SROs but it seems ridiculous to maintain separate industry bodies for specific functions when these are now all covered by a single law. But merging these is unsettling for the funds industry. The JSDA is ônot friendlyö toward the asset management and hedge-funds industry, say several sources.

ôWe need best practices developed by our own SRO,ö says one industry executive.
The FSA says it cannot comment because this is an industry matter. But without its guidance, the industry is unsure whether or how SROs will be rationalised. And if the SROs remain unchanged, then a lot of the benefits of streamlining the law under the FIEL wonÆt be realised.

After so much work, it would be a pity for special interests to undermine the progress embodied by the FIEL. If Japan wants to set the pace for quality regulation, it needs to ensure that entrenched interests donÆt undermine the spirit of the new law.

After that it remains to be seen whether hedge funds indeed value æqualityÆ regulation versus the laissez-faire approach of other jurisdictions.