Startup companies using innovative and novel technologies (eg blockchain and related fintech), real estate companies, and financial institutions have moved towards the trend of securitizing real estate assets through “digital securities”. This new development may expand investment in real estate, especially by individuals by lowering the barrier to entry for real estate assets.
An amendment to Japan’s Financial Instruments and Exchange Act (the FIEA) relating to regulations applicable to security token offerings (STOs) came into effect on May 1, 2020. Under STOs, security tokens representing investors’ rights are offered to investors instead of certificates representing the same rights, which makes assignment of investors’ rights easier. The main purposes of this amendment are to provide clarity to the market regarding the regulations applicable to STOs and to provide enhanced protection to investors. The amendment to the FIEA introduced the concept of Electronically Recorded Transferable Rights (ERTRs) (denshi kiroku iten kenri). Tokens issued through an STO that fall under the definition of ERTRs are subject to the amended regulations under the FIEA. In this case, several additional licensing requirements and disclosure obligations apply.
Definition of ERTRs
Under the amended FIEA, ERTRs are defined as rights that:
- fall under deemed securities (meaning securities that are not usually indicated on certificates) set forth in Article 2, Paragraph 2 of the FIEA (Paragraph 2 Securities); and
- are represented by a proprietary value that is transferrable by means of an electronic data processing system (limited to cases where the proprietary value is recorded by an electronic device or otherwise by electronic means). Under the FIEA guidance published in May 2020, if the rewriting of a book managed by the issuer, etc. which records the right holders, the number of the right, etc. (which rewriting means transfer of the proprietary value) and transfer of the right are contractually or actually performed as a series of transactions, basically the right falls under ERTRs.
Generally speaking, digital tokens fall under the second point above.
ERTRs are treated not as Paragraph 2 Securities but as Paragraph 1 Securities (meaning securities that are usually indicated on a relevant certificate). Paragraph 2 Securities include, without limitation, trust beneficiary interests, membership interests in a godo kaisha (which is a company similar to a limited liability company) and collective investment scheme interests1 (CISIs) such as partnership (kumiai) interests or silent partnership (tokumei kumiai) interests for investments. Since Paragraph 2 securities usually do not have high assignability compared to Paragraph 1 Securities, relaxed regulations apply to Paragraph 2 Securities. ERTRs can have high assignability as a result of the use of an electronic data processing system (such as digital tokens), and as a result ERTRs are treated as Paragraph 1 Securities to which stricter regulations apply to protect investors.
If a digital token does not have high assignability, there’s no need to impose such strict regulations. As such, the amendment to the FIEA establishes some exceptions for rights represented by digital tokens not treated as ERTRs: for example, if:
- a digital token cannot technically be assigned to anyone other than a qualified institutional investor (QII) or other investors who are considered to have appropriate investment knowledge; and
- each transfer of such digital tokens technically requires a request for approval of the issuer by the transferor and approval by the issuer.
Regulations on ERTRs
Disclosure Obligation for Issuance
If solicitations are made to 50 or more investors for an offering or a secondary distribution of ERTRs, and unless the requirements for private placements (either with QIIs, with special investors, or with a small number of investors) are met, issuers of ERTRs are required to file a securities registration statement (yuka shoken todokede-sho) with the relevant authority and must also issue a related prospectus (mokuromi-sho).
Annual Securities Report and Semi-Annual Securities Report
Issuers of ERTRs who were required to file a securities registration statement with the relevant authority are also required to file annual securities reports (yuka shoken hokoku-sho) and semi-annual securities reports (hanki hokoku-sho).
Issuers of ERTRs representing Paragraph 2 Securities (such as trust beneficiary interests, membership interests in a godo kaisha and CISIs) are now required to register as a Type 2 Financial Instrument Business Operator unless they use a licensed business operator to handle solicitations of such ERTRs or they themselves meet the requirements for a Specifically Permitted Business for QIIs which include, without limitation,
- investors must include at least one QII;
- the number of the other non-QII investors must be 49 or less; and
- such other non-QII investors must be considered to have appropriate investment knowledge or are closely related to the issuer.
A person who handles solicitations of ERTRs on behalf of the issuer must be registered as a Type 1 Financial Instrument Business Operator since ERTRs are classified not as Paragraph 2 Securities but as Paragraph 1 Securities.
This amendment provides the market with clarity relating to the regulations applicable to digital securitization in Japan and enhanced protection of investors as the market matures and expands. It’s expected that investment in real estate through STOs will expand and that many Japanese and foreign companies will start working to create an active real estate tokenization market.