alerts & publications
Global Funds NewsletterNovember 29, 2010
Introducing the new Global Funds Newsletter from O’Melveny & Myers LLP. We will be bringing you our perspectives on the developments and deals going on in the funds markets around the world. Our inaugural issue launches with a look at regulatory developments in the UK, US & EU before taking in developments from India, China, Japan and the US.
Europe: Regulation - much change and detail to come
USA: FATCA: Comply and Disclose, or else!
USA: SEC’s Pay to Play
Asia: India’s proposed tax code may compel sponsors to move PE funds from Mauritius
Asia: Fund Solicitation and Management In Japan
Asia: Rising Chinese Institutional Limited Partners
The regulatory landscape is changing, but important detail is awaited.
It is difficult not to have some skepticism about it all:
- governmental and supranational bodies urge concerted action, but local interests mean that 'joined-up thinking' does not always occur;
- politicians have set agendas, but may be thought to have left regulatory bodies to try and make sense of it all, as well as to implement it;
- detail does not always result in understandable and workable provisions;
- more regulation is not necessarily better regulation; and
- regulatory changes that will bite on banks and insurance companies (not the subject of this piece) may well reduce their resources to invest in Private Equity.
Currently non-U.S. fund managers wrestle with the Foreign Account Tax Compliance Act (‘‘FATCA’’), pay-to-play rules, and broker-dealer issues.
Now they have to add the spectre of the Dodd-Frank Act (to truncate its full name) and whether they need to register as an investment adviser. Proposals (as a precursor to actual rules) have emerged and July 2011 is not far away. "Foreign private investors" will be able to avail themselves of the less than $150m assets under management in the USA exemption or only the less than $25m attributable to U.S. investors and clients exemption? While it may be clear to some, even now, that they will have to register, for others further detail may be vital to a determination. Please see our recent client alert at http://www.omm.com/the-new-swaps-regulatory-framework-under-dodd-frank-08-11-2010/. Further analysis will follow in the subsequent edition.
At least the United States is not embarking on a wholesale reshuffle of its regulators.
The Alternative Investment Fund Managers Directive (“AIFMD”) has just been agreed upon. However, there are numerous areas of the Directive that will require further implementation measures and there the EU Commission may have a “freer hand” to do what it likes. Further lobbying by the Private Equity and Hedge Fund industries will be needed.
The EU “alphabet soup” of regulatory bodies is changing. How will Private Equity be affected by CESR becoming ESMA and by EU regulators having extended powers over member states’ own regulators?
Plenty is happening in the UK, even leaving aside keen interest in what is happening in the United States and Europe and wondering what all information will have to be provided to whom and to fulfill what agenda.
The current roles of FSA and the Bank of England are to change. There is a consultation in progress about this, but preparation being made suggests the course is already largely set. Will the split up of the existing functions of FSA really mean much change for the bulk of FSA regulated firms? Will it only be those prudentially regulated by the Bank of England’s new subsidiary (the Prudential Regulatory Authority) that really see change, being additionally, conduct regulated by the renamed FSA (the Consumer Protection and Markets Authority)? Where will responsibility for enforcement powers end up and what changes in the enforcement climate will ensue?
How will the changes on the remuneration front pan out? What will be "proportionate" application of the FSA remuneration Code? What staff will be covered? How will (can?) some of the provisions be applied to LLPs (the structure of choice for UK managers), carried interest and co-invest? And, then the AIFMD’s remuneration provisions will further affect FSA’s Code.
Then there are changes to the approved person regime and the definition of Qualified Partnerships, the impact of the Retail Distribution Review (with "packaged products" being relabelled and extended to unregulated collective investment schemes) and the question of which firms will be 'in scope' for "recovery and resolution plans" all to look forward to.
And do not forget the Bribery Act 2010, coming into force next April. What should your prevention of bribery procedures say? And will you still be able to entertain (drown your sorrows with) your clients?
In summary, some might think not what Private Equity needs — lots of change and plenty of uncertainty, work and expense; and how much of it is of benefit to the institutional limited partner client base?
By Alasdair Gordon
FATCA: Comply and Disclose, or Else!
Provisions for U.S. Withholding Tax on Payments to Foreign (i.e., non-U.S.) Financial Institutions and Non-Financial Foreign (i.e., non-U.S.) Entities and Related Tax Disclosure
On March 18, 2010, new provisions of the Foreign Account Tax Compliance Act of 2009 ("FATCA") related to information reporting and withholding were signed into U.S. law as part of the Hiring Incentives to Restore Employment Act. This is one of the more recent examples of the U.S. Government’s high-profile clampdown on perceived tax avoidance by U.S. taxpayers.
The purpose of FATCA is to enhance the ability of the U.S. Internal Revenue Service (the “IRS”) to collect data from institutions outside the U.S. in respect of assets held abroad by certain U.S. persons. The legislation seeks to achieve this through the imposition of reporting obligations upon certain entities, including investment vehicles, which are established outside the United States. In order to encourage compliance with these reporting obligations where they apply, the measures also include a sting in the tail in the form of a potential 30% withholding tax on most types of U.S. source investment income and gross proceeds from the disposition of many U.S. securities in the event of noncompliance.
This article is a summary of the key implications of the FATCA provisions for our clients and their transactions. The U.S. tax team of O’Melveny & Myers (‘‘OMM’’) will be happy to discuss the finer details of these new rules and their impact on a case-by-case basis.
FATCA generally imposes a 30% withholding tax on payments of certain U.S.-source income and gross proceeds from the disposition of many U.S. securities made to a foreign (non-U.S.) entity unless the entity satisfies applicable information reporting requirements. Although these rules generally will not have effect until January 2013, organisations subject to FATCA should already be considering whether to comply with the relevant reporting regime and, if the intent is to comply, how to implement the appropriate processes and systems to facilitate compliance so as to avoid being subjected to the FATCA withholding tax.
The objective of FATCA is not to raise revenue through the imposition of the withholding tax that the act introduces. Rather, FATCA aims to enhance the enforcement of the U.S. tax system (and thereby indirectly facilitate the collection of additional revenue) in respect of certain U.S. taxpayers’ assets held abroad. The FATCA withholding tax is intended to serve as the stick to encourage compliance with the new disclosure regime, and will be imposed only if a non-U.S. person subject to this regime has failed to comply with applicable reporting requirements which, in some cases, will require entering into an agreement with the IRS to provide details relating to its direct and indirect U.S. owners, creditors, and/or accountholders (as discussed further below).
FATCA introduces, broadly speaking, two tiers of reporting regimes, the more burdensome of which applies to “foreign financial institutions” (as defined in the legislation, examined below, and commonly referred to as “FFIs”) and which will include many of our clients. The less burdensome regime applies to non-U.S. entities that are not FFIs and are categorised instead as “non-financial foreign entities” (commonly referred to as “NFFEs”). Although we expect that clients are likely to call on their regular in-house tax and tax compliance advisers (such as the Big 4 accounting firms) to devise compliance procedures and systems, OMM’s U.S. tax team is prepared to assist clients with their risk assessments.
Clients who are setting up new funds, or investing in new funds, should ensure that appropriate provisions are included in the fund documentation to ensure that FATCA-related issues are adequately addressed. Clients may also need to consider how to deal with FATCA issues in the context of existing funds where fund documentation did not contemplate the new rules and existing tax language is insufficient. This may include engaging in a dialogue with the managers of such funds to understand how they intend to ensure compliance with the new rules.
Foreign Financial Institutions
The provisions relating to FFIs are likely to be of most relevance to our clients, and so the following paragraphs summarise those provisions first and then comment briefly on the provisions applicable to NFFEs.
Who Will Need to Think About Disclosure?
Generally speaking, non-U.S. investment funds (many of which are likely to be FFIs, as explained below) which have investments that may generate U.S.-source income or profits will need to consider whether they may be subject to FATCA and, if so, whether it is sensible for them to comply with its disclosure requirements (regardless of whether such investment funds have any U.S. investors).
The FATCA provisions impose a 30% U.S. withholding tax on certain “withholdable payments” made to an FFI.
In addition to including non-U.S. entities that accept deposits in the ordinary course of business (e.g., banks) or that are engaged in the business of holding financial assets for the accounts of others (e.g., brokerages), FFI has been defined to include non-U.S. entities engaged primarily in the business of investing or trading in securities, partnership interests or commodities, or any interests therein. Accordingly, the term captures not only non-U.S. banks and non-U.S. brokers, but also most offshore funds.
The U.S. Treasury Department (the “Treasury”) has broad regulatory authority to exempt certain classes of entities from treatment as FFIs. Final guidance has yet to be issued to indicate which types of entities are likely to benefit from exemptions. However, early indications are that while certain non-U.S. entities that entail a low risk of tax evasion (e.g., certain holding companies and financing subsidiaries of groups that are not engaged in a financial business, certain limited classes of insurance or reinsurance companies, and certain non-U.S. retirement plans) will be wholly or partially exempt from FATCA, the Treasury may not be intent on exempting broader classes of non-U.S. entities.
FATCA defines a withholdable payment as including: (i) most types of U.S.-source income (notably including U.S.-source interest and dividend payments); and (ii) gross proceeds from the sale or disposition of any property which could produce U.S. source interest or dividends (regardless of whether such sale or disposition is at a gain or at a loss). No withholding would be required for income treated (and generally taxable) as income effectively connected with a U.S. trade or business.
Accordingly, under FATCA, if a non-U.S. fund entity is an FFI, income and profits arising to such a fund in respect of its U.S. investments will likely be subject to the 30% withholding tax unless the fund has entered into a disclosure agreement with the IRS (discussed below) or is otherwise exempted (also discussed below).
As alluded to above, an exemption from the withholding tax is provided in respect of payments otherwise subject to the tax if such payments are made to FFIs which have entered into a disclosure agreement with the IRS. Early guidance in the form of an IRS notice issued on August 27, 2010, refers to this agreement as an “FFI Agreement.”
Subject to modification via guidance which is to be published by the IRS, an FFI under an FFI Agreement would generally be required to provide to the IRS on an annual basis the following details in respect of each “U.S. account’”" maintained by it (or certain of its affiliates):
(i) the identifying information of each “specified U.S. person” who owns accounts with an aggregate value exceeding $50,000 and, if the account holder is a foreign entity, of each “substantial U.S. owner” of the entity;
(ii) the account number;
(iii) the account balance or value; and
(iv) the gross receipts and gross withdrawals or payments from the account.
A U.S. account for these purposes would include any financial account held by a specified U.S. person or a U.S.-owned foreign entity. Financial account is in turn defined to include depository accounts, custodial accounts, and most non-publicly traded equity or debt interests in the subject financial institution.
A specified U.S. person includes any U.S. person who is not a U.S. tax-exempt organisation, publicly traded corporation (or certain affiliates thereof), U.S. federal, state, or local agency, bank, real estate investment trust, or regulated investment company, common trust fund, or a certain type of tax-exempt trust. A substantial U.S. owner generally is a specified U.S. person owning directly or indirectly at least 10% of a non-U.S. entity. However, a special rule applies to non-U.S. entities that are FFIs by virtue of their status as investment vehicles (such as most offshore funds): as to them any specified U.S. person who holds any interest in the entity is a substantial U.S. owner.
Under guidance to be provided by the Treasury, certain FFIs may be effectively exempted in whole or in part from the above-described disclosure requirements. In particular, there may also be exemptions for: (i) FFIs which have complied with certain procedures (yet to be prescribed by the Treasury) to ensure that the institution does not maintain U.S. accounts; and (ii) FFIs with respect to which the Treasury has determined that the application of these requirements is unnecessary. The IRS notice issued in August 2010 suggests that the Treasury may be devising relatively narrow classes of exempted FFIs. For example, in the fund context, the IRS notice could be read as implying a limited interest in possibly exempting certain “Undertakings For The Collective Investment Of Transferable Securities” (UCITS) marketed to EU investors, rather than a broader interest in exempting offshore funds that do not accept U.S. investors or existing specification vehicles for which compliance with FATCA may prove practically impossible. Treasury has received comments in response to the notice request that offshore funds that do not accept U.S. investors as a matter of policy (e.g., because they wish to avoid compliance with U.S. securities laws) be exempt from FATCA on the basis that such funds pose a low risk of enabling U.S. tax evasion. It is unclear how Treasury will respond to these requests.
Additionally, an FFI generally will not be required to satisfy reporting obligations with respect to any financial account it maintains on behalf of: (i) another FFI if such other FFI is, itself, compliant with the requirements of FATCA; or (ii) an account holder that is “otherwise subject to information reporting requirements” which would in the view of the Treasury make these reporting requirements duplicative.
Non-Financial Foreign Entities
The 30% withholding tax also applies to withholdable payments made to NFFEs that fail to comply with applicable due diligence and information reporting requirements. For these purposes, an NFFE is any non-U.S. entity which is not an FFI. However, to the extent such persons are acting for their own account, certain specified NFFEs (including, publicly traded corporations and certain of their affiliates, certain entities organised in a U.S. “possession”, non-U.S. governments or international organisations (and their respective political subdivisions and agencies or instrumentalities), and non-U.S. central banks are generally exempt from the FATCA withholding and information reporting regime. The Treasury has the authority to expand this exemption to other classes of non-U.S. persons and to classes of payments determined to pose a low risk of tax evasion.
Subject to the above-mentioned exceptions, withholding generally will be required on a withholdable payment to an NFFE if the beneficial owner of the payment is either the NFFE itself, or another NFFE, unless (A) the beneficial owner either: (i) provides the withholding agent with a certification that the beneficial owner does not have any substantial U.S. owners, or (ii) discloses the identities of each substantial U.S. owner, (B) the withholding agent does not know or have reason to know that any of the information so provided is incorrect, and (C) the withholding agent reports the information so provided to the Treasury. Details regarding the time and manner of such reporting by the withholding agent have not yet been provided.
For purposes of FATCA, withholding agent is broadly defined; it includes any person (whether U.S. or non-U.S.) who, in whatever capacity acting, has control, receipt, custody, or payment of any withholdable payment. Accordingly, a typical fund (whether U.S. or non-U.S.) is likely to be a withholding agent for purposes of FATCA. As such, it will be required to determine whether any of its investors, creditors, or other payees are FFIs or NFFEs, which will require the collection of certain information and/or certifications from its payees. The details of these requirements are still under consideration.
The introduction of FATCA will no doubt have a considerable effect on the financial sector, including many of our clients. In particular, institutions which fall within the scope of FATCA will need to adopt major new systems and processes to ensure compliance, and the time frame for doing so is relatively short. As a first step, any institution which may potentially be affected by the new legislation (either due to its status as an FFI or an NFFE, or as a withholding agent with respect to withholdable payments) should ensure that it has a thorough understanding of the new rules, and the extent to which the rules impact upon its operations. Please do not hesitate to contact a member of OMM’s U.S. tax team for an initial high-level discussion or a more detailed analysis of FATCA and its impact on your business.
IRS Circular 230 Disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. tax advice contained in this bulletin (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of: (i) avoiding penalties under the U.S. Internal Revenue Code, or (ii) promoting, marketing, or recommending to another party any matters addressed herein.
By Janice Seah
SEC’s Pay to Play
On June 30, 2010, the Securities and Exchange Commission (“SEC”) adopted a new “pay-to-play” rule (“the Rule”), which generally applies to investment advisers providing advice to government entities (“covered advisers”). Most significantly, the Rule bans covered advisers from receiving compensation for two years for providing advisory services either to a government entity or, on a pro rata basis, to private investment vehicles containing government funds, if the covered adviser (or certain of its “key” employees) makes a political contribution to a covered public official in that jurisdiction.
Who Is Covered? SEC-registered investment advisers, or advisers relying on the private adviser exemption from registration under section 203(b)(3) of the Investment Advisers Act of 1940, that also provide direct or indirect advisory services to a government entity, are covered by the Rule. Key employees of the covered adviser include, for example, general partners, managing members, executive officers, others with similar management and executive status or functions, and employees engaged in the solicitation of government entities for advisory services (including the solicitation of government pension funds for sales of private fund interests). The SEC applies a functional-based approach to determining if an employee is covered, and thus any employee with a policymaking function or responsibility for soliciting government business is covered by the Rule, regardless of title.
What Kind of Political Contributions Are Covered? A contribution for the purposes of the Rule includes a gift, subscription, loan, advance, deposit of money, or anything of value, as well as an in-kind contribution (e.g., an employee spends time on a campaign during business hours or otherwise uses the adviser’s resources), only if the contribution: (i) is made in connection with an election, or (ii) pays for transition or inaugural expenses incurred by a successful candidate for state or local office. A covered employee, however, may contribute up to $350 per election to a candidate, if the employee is entitled to vote for the candidate at the time of the contribution, and may contribute up to $150 per election to a candidate, if the employee is not entitled to vote for the candidate at the time of the contribution.
Which Politicians Are Covered? The Rule applies only to contributions made to a public official who, at the time of the contribution, was an incumbent, a candidate, or a successful candidate for an elective office of a government entity, if the office in question either: (i) has the authority to select or influence the selection of an investment adviser for the government entity, or (ii) has the authority to appoint a person who has the power to select or influence the selection of an investment adviser for the government entity. A “government entity” is defined by the Rule to include: any state or political subdivision of the state, including agencies, authorities, and instrumentalities; a pool of assets sponsored or established by the government entity; a plan or program of the government entity; or officers, agents, or employees of the government entity acting in their official capacity.
Additional Requirements. Besides its primary prohibition on political contributions, the Rule has several other components. First, the Rule bans covered advisers and covered employees from hosting fundraisers or otherwise engaging in political fundraising for covered officials and state and local political parties. Second, the Rule contains an anti-circumvention provision that strictly prohibits advisers from making “conduit” contributions to covered officials through third parties, such as political action committees and family members. This provision is intended to prohibit covered advisers from doing anything indirectly that they would be prohibited from doing directly. Lastly, the Rule prohibits covered advisers from using such third-party solicitors unless the solicitor is appropriately registered as a broker-dealer (a placement agent) subject to similar pay-to-play restrictions imposed by the Financial Industry Regulatory Authority, Inc. (‘‘FINRA’’), or as an investment adviser subject to the Rule. FINRA is formulating a pay-to-play rule for registered placement agents and should be promulgating that rule in the near future.
Important Compliance Dates. Although the Rule formally went into effect on September 13, 2010, covered advisers have until March 14, 2011, to adopt and implement policies and procedures in compliance with the Rule’s contribution restrictions and recordkeeping requirements. Covered advisers to registered investment companies have until September 13, 2011, to comply. All covered advisers have until September 13, 2011, to comply with the restriction on the use of third-party solicitors.
By Barb Stettner and Charles Borden
To date, many India-focused private equity funds have been domiciled in Mauritius with a view to benefiting from the double tax avoidance treaty between Mauritius and India. If the requirements of this treaty are satisfied, investors are able to avoid paying capital gains tax in India, a tax which can reach as high as thirty percent. However, the effect of India’s proposed direct tax code may compel fund sponsors to shift their fund domicile.
The Indian tax authorities have long argued that there is little commercial rationale for an India-focused private equity fund to have a Mauritian domicile, except to achieve tax efficiency, and that such funds have little or no “substance” in Mauritius as the fund vehicles are merely shell companies managed by professional administrators rather than by the real decision makers. Despite the fact that this fund structure — and other forms of foreign direct investment into India via Mauritius — has been under constant review by the Indian tax authorities, proponents of Mauritian structures can take comfort from a ruling by the Indian Supreme Court, which has generally been supportive of the treaty.
However, this could change in light of India’s proposed direct tax code, which would challenge the treaty by incorporating general anti-avoidance rules that prohibit arrangements where there is no commercial rationale for such arrangements other than the avoidance of tax. These rules, if legislated, will likely impact many existing Mauritius-based fund structures that have insufficient substance in Mauritius. These rules may also require new funds to rethink their strategies and devise alternative tax-efficient structures that do not violate the new rules.
Should the direct tax code be implemented, Singapore would be the most likely alternative fund domicile to a less desirable Mauritius. Singapore also has an attractive tax treaty with India, with provisions similar to those of the current Indo-Mauritius treaty. Furthermore, Singapore is a more credible hub for Asian financial services activity given its sophisticated talent pool and geographical proximity to India, which makes it easier to demonstrate commercial rationale and substance in fund entities domiciled in Singapore. Unlike the Indo-Mauritius treaty, the Singapore treaty limits benefits to Singaporean entities that have an annual expenditure of at least SGD 200,000 (approximately US$155,000), a requirement that should not be a significant deterrent to sponsors who choose Singapore as the domicile for their funds. The Indo-Singapore treaty also provides double taxation benefits on interest income (unlike the Indo-Mauritius treaty). In addition, Singapore has developed resident fund tax exemption rules to protect funds from Singapore level tax. Incentives for fund management companies in Singapore are also favorable for teams based there.
Utilising Singapore as a fund domicile does have its drawbacks. These include a lack of familiarity for international investors with the jurisdiction as a domicile for private equity funds, a requirement for the fund to pay a goods-and-services tax to any service providers in Singapore (such as the fund manager and a custodian), significant compliance burdens in order to utilize the resident fund exemption, and some relatively inflexible company law provisions that need to be navigated in order to make distributions to investors. The treatment of carried interest and its possible relationship to the tax incentives provided to fund managers in Singapore also require careful analysis.
Despite these drawbacks, sponsors of Mauritian fund entities are already giving serious consideration to Singapore, and have set up or expanded existing offices in Singapore. This will allow such sponsors an element of flexibility in terms of moving their fund entities from Mauritius to Singapore, if need be.
The Indian authorities would have us believe that the proposed direct tax code has not been targeted specifically at private equity funds but rather at what they regard as exploitation of the Indo-Mauritius treaty in general. The irony is that while sponsors may experience a degree of inconvenience should they choose to relocate their operations to Singapore, their funds will nonetheless continue to benefit from an exemption from capital gains tax, and meanwhile, the net effect for India could be more damaging, with highly paid investment executives spending time (and therefore income) in Singapore (or elsewhere) that may otherwise have been spent in India. When it comes to private equity funds, therefore, Singapore rather than the Indian tax authorities could be the true beneficiary of the proposed direct tax code.
By Anirudh Rastogi and Dean Collins
Fund Solicitation and Management in Japan
Recent news that Japan may need to tap into its public pension reserves in 2011 to cover shortfalls in benefits, coupled with the discovery that the pensions of Japan Airlines and other large Japanese companies are significantly underfunded, may present an opportunity for foreign fund managers. After two decades of stagnant domestic financial markets and a rapidly aging population, growing evidence suggests that Japanese public and private pensions may start to allocate more capital to foreign and alternative investments in the search for higher returns. These trends—and the recent rise of the yen—are bringing foreign fund managers back to Japan.
In light of these circumstances, it is important for foreign fund managers to understand Japanese rules on fund solicitation and management. On September 30, 2007, the Financial Instruments and Exchange Law (the “FIEL”) took effect, marking the first time that so-called collective investment schemes became systematically regulated under Japanese law. Foreign limited partnership interests, such as interests in a Cayman limited partnership or a Delaware limited partnership, which generally fall into the category of collective investment schemes, would be subject to the regulations.
As more funds now look to raise money in Japan, we are regularly asked how the FIEL affects foreign fund solicitation and management activities in Japan. This article aims to provide a snapshot of regulations and tips with respect to: (i) disclosure requirements that apply to solicitation of foreign fund interests; (ii) business registration requirements that apply to funds that solicit foreign fund interests; and (iii) business registration requirements that apply to management activities of foreign funds.
2. Disclosure - Qualifying as a Private Placement
In Japan, interests in an investment fund must be registered with the Financial Services Agency of Japan (“JFSA”) prior to their offering or sale unless an exemption applies. In order to qualify as a private placement and avoid the registration requirements, the number of investors residing in or solicited in Japan (“Japanese Investors”) must be 499 or less. There is no limit on the number of Japanese Investors that may be solicited, but rather it is the number of Japanese Investors that actually invest which must be limited to 499. Further, the number of Japanese Investors must not exceed 499 as a result of any transfers of partnership interests following the placement, or the interests will become subject to disclosure requirements. Accordingly, O’Melveny & Myers LLP recommends that appropriate transfer restrictions be included in the limited partnership or subscription agreements even though transfer restrictions are not required by the FIEL. Written notice containing certain statements stipulated in the FIEL must also be delivered to the Japanese Investors on or prior to the acquisition of the fund interest.This notice may be included in the private placement memorandum or the limited partnership agreement, or it may be delivered separately.
3. Business Registration - Solicitation Activities and Registration Requirement - Qualifying for Exemption
The solicitation of foreign fund interests to Japanese Investors may only be conducted by one or more of the following: (i) a registered broker-dealer conducting Type II Financial Instruments Business (dai nishu kinyu shohin torihiki gyo) or (ii) the fund itself. When the fund solicits foreign fund interests, the general partner of the fund must have a Type II Financial Instruments Business registration unless the solicitation qualifies as “QII Special Business (tekikakukikan toshika to tokurei gyomu)” which is exempt from the business registration requirements.
For a foreign fund’s solicitation activities to qualify as QII Special Business, the fund must comply with the private placement rules and satisfy the following requirements: (i) the general partner of the foreign fund must file a notice with the JFSA (which includes certain information about the general partner, such as the name, type of business, and amount of capital of the general partner) prior to the commencement of any solicitation activities to Japanese Investors; (ii) at least one Japanese Investor must be a “qualified institutional investor (tekikakukikan toshika)” (“QII”) as such term is defined in the FIEL; (iii) the number of non-QII Japanese Investors investing in the foreign fund must not exceed forty-nine (including the number of Japanese Investors acquiring the fund interests during any six-month period); (iv) none of the Japanese Investors are disqualified investors as described in the FIEL; and (v) the transferability of the fund interests is restricted in the manner required by the FIEL. Accordingly, we advise that certain representations and warranties be included in subscription agreements or limited partnership agreements—for example, that the investor is a QII and not a disqualified investor.
Many foreign funds seek to meet the requirements to qualify for the QII Special Business exemption or else leave the solicitation activities in Japan entirely to a local registered broker-dealer. With respect to solicitation activities, we regularly give clients two pieces of advice: First, in either seeking to qualify for the QII Special Business exemption or leaving the solicitation activities to a local registered broker-dealer, make sure that the fund manager of the foreign fund is not involved in any solicitation activities unless he is registered as conducting Type II Financial Instruments Business under the FIEL. Since the scope of solicitation is broadly interpreted under the FIEL, any mention of a specific fund by the fund manager (either physically or electronically) to the Japanese Investors could be regarded as solicitation. Although precautions in this respect should be taken, a fund manager’s introduction of the fund management team or explanation of the track records of prior funds to Japanese Investors before marketing a specific fund interest should be permissible. Second, when seeking to qualify for the QII Special Business exemption, make sure that solicitation activities are made only by directors, officers, or employees of the general partner and not the manager of the fund in its name and as its representative. For example, all materials relating to the solicitation (e.g., cover letters accompanying the private placement memorandum, business cards delivered) provided by any representative should be in the name of the general partner. It is also important to maintain records that show that solicitation has been conducted only by the representatives in the name of the general partner.
4. Business Registration - Fund Management Activities and Registration Requirement - Qualifying for Exemption
If more than 50% of a fund’s investments is expected to be in “securities” and “derivative instruments” as defined under the FIEL, the general partner of the fund needs to be registered to engage in “Investment Management Business (toshi unyogyo)” unless management of the fund is completely delegated to an investment manager registered in Japan and other requirements stipulated in the FIEL are satisfied.
However, there are two exemptions which may apply to foreign funds. The first exemption is the QII Special Business exemption, whose requirements are the same as the one for solicitation purposes except that no transfer restrictions apply. The notice needs to be filed prior to commencing fund management activities (most typically investments). This notice is technically separate from the notice to obtain exemption from registration for solicitation purpose but may be and typically is filed in a single notice. The second exemption is the so-called “QII Only Foreign Fund” exemption. The fund does not need to file a notice if (i) the fund is a fund formed under a jurisdiction other than Japan; (ii) Japanese Investors are all QIIs (or the Japanese Investors invest indirectly through a Japanese fund whose investors are all QIIs and that qualify for the QII Special Business exemption); (iii) the aggregate number of Japanese Investors that are QIIs (direct and indirect) is less than ten; and (iv) the aggregate amount invested by the Japanese Investors does not exceed one-third of the total investment amount and assets of the fund.
Please note that in order to enjoy either the QII Special Business exemption or QII Only Foreign Fund exemption, the requirements to qualify must be maintained throughout the life of the fund. Accordingly, the fund is advised to put appropriate mechanisms in place to continuously monitor and ensure that it meets the relevant requirements.
 QIIs are, for example, banks, securities companies, or insurance companies authorized by the Japanese government or investors who are registered as QIIs to the JFSA.
 Although this arrangement could be achieved through the secondment from the fund manger, the authority will look at the scope and nature or the “substance” of the secondment to determine whether the secondment is a “true” secondment.
By Dale Araki, Hiroki Sugita, Scott Sugino, and Masatoshi Terasawa
The rise of Renminbi (‘‘RMB’’) denominated private equity funds has attracted much focus in recent years, with many of the major global private equity players either announcing their entrance into the onshore fundraising market or spending considerable time raising funds in China. For good reason: the amount of capital raised from Chinese Limited Partners (‘‘LPs’’) to RMB funds increased sevenfold in the period 2006–2009, and outstripped demand for U.S. dollar denominated funds targeting Chinese investment for the first time in 2009. O’Melveny & Myers LLP has already closed RMB denominated funds for fifteen fund sponsors and is currently working with another ten sponsors on RMB fund plans.
Whilst most of the analysis to date has focused on fund sponsors, recent developments are shifting attention to the Chinese LP base. These include an announcement by the National Social Security Fund of China (“NSSF”) that it intends to make investments in a number of foreign funds of funds and the decision by the China Insurance Regulatory Commission (“CIRC”) to permit Chinese insurance companies to make private equity investments.
In September 2010, the NSSF announced plans to make investments in a number of foreign funds of funds. This decision reflects the confluence of a variety of factors, including policy-level regulatory developments, the end of a ramping-up period by NSSF with domestic LP side investments, and analysis of the private equity foreign market. With more than RMB776 billion (equivalent to US$116 billion) of assets under management by the end of 2009, the NSSF has long been a major institutional LP in the RMB-funds space. According to a recent announcement made by Mr. Xianglong Dai (Chairman of NSSF), NSSF will, by the end of 2010, invest for the first time in a number of foreign funds of funds, with a view to making direct investments overseas in the long term. According to the NSSF’s foreign investment regulation, 20% of the NSSF’s assets (equivalent to US$23 billion) can be used for foreign investments; of that, 7% already has been allocated (and of this amount, approximately US$150 million was allocated to private equity). It therefore seems likely that more general partners will solicit investment by the NSSF to tap this large funding allocation.
Whilst insurers have long been major players in the global private equity funds market, only a few large insurance companies in China were permitted to allocate a portion of their insurance funds to private equity investments, and only in certain specified industries with the approval of the CIRC. As of August 2010, Chinese insurance companies are officially permitted to make private equity investments, including through funds managed by third parties. An estimated RMB200 billion (equivalent to US$29.8 billion) will be available for investment by Chinese insurance companies in the asset class, which will provide a significant boost to the Chinese private equity industry. Unlike the previous pilot programs, which restricted private equity investments by insurance companies to infrastructure companies and commercial banks, there is generally no restriction on the industries of the portfolio companies (save for a few specific exceptions). This regulation therefore allows insurance companies to diversify their premium base in line with international norms. Notably, this development may also cause Chinese insurance companies to invest offshore (following the trend which is developing with the NSSF).
By Jingyi Xu
O’Melveny & Myers has recently cooperated with China Venture Capital Association to publish a detailed report on Chinese domestic LPs. Please contact us by clicking here if you would like to receive a copy.
 Source of data: http://www.ssf.gov.cn/tzsj/201005/t20100506_2682.html
 The Provisional Measures on Administration of Foreign Investments by National Social Security Fund issued by the NSSF in March 2006.
 Up to 5% may be invested into private equity. The cap is set at 4% if an insurance company engages only in indirect investments, such as investments through private equity funds.
 The exceptions dictate that an insurance company may not: (i) invest in private equity or real estate projects that are not in line with the state’s industrial policies, such as projects that are highly polluting or with uncertain expected cash flows or asset appreciation; (ii) engage directly in real estate development and construction; or (iii) engage in venture capital investments.
 According to Preqin's Investor Intelligence database, insurance companies aim to allocate 3.7% of their total assets to private equity.
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