Evolution of Market’s Legal Framework
Background
Small-lot real estate investment products first appeared in 1987, enabling smaller retail investors to invest in real estate by breaking down investment in such assets to a feasible scale while also enhancing their liquidity. However, these small-lot products lacked any measures to protect investors, who suffered huge losses with the precipitous fall in asset prices after the collapse of Japan’s bubble shortly thereafter.
The real estate securitization market in Japan largely evolved from the aftermath of this collapse. Subsequent calls for the establishment of a legal framework to develop full-fledged real estate securitization in Japan resulted in a series of laws that established this framework in stages.
Real Estate Syndication Act
The Real Estate Syndication Act (RSA), enacted in 1995 and revised in 1997, was the first legislation passed toward these aims. In addition to establishing the first specific securitization structures, known as nin’i kumiai (NKs; voluntary partnerships) and tokumei kumiai (TKs; Anonymous Associations), the RSA instituted a permit system for parties in real estate transactions that required a minimum amount of paid-in capital, a realtor’s license, proven expertise regarding the real estate market and heightened disclosure on investment activities and financial status. Thereafter, real estate investment was required to conduct more rigorous financial analysis and due diligence, such as through real estate appraisals, and new forms of capital raising and asset management pertaining to securitized real estate were promoted.
“Big Bang” Deregulation of Financial System
During the late 1990s, reforms to the Japanese financial system were being considered as part of a financial “Big Bang” following the Asian financial crisis. These measures were largely concerned with providing the means to dispose of the massive amount of non-performing loans plaguing the market at the time while facilitating a Japanese financial system that was freer, fairer and more able to compete with the financial system’s of other countries amid the increasing globalizing and sophistication of financial markets worldwide.
The Law on Securitization of Specific Assets by TMKs, known as the “former SPC Law,” was the first law to provide for comprehensive asset securitization in Japan. This law not only provided an effective means to dispose of these non-performing loans, but also enabled companies to raise funds for asset acquisitions based on the creditworthiness of the assets themselves. The former SPC Law also specifically identified real estate as an asset that could be securitized. Other laws, such as the Act on Securitization of Assets, were enacted to clarify interpretation of the former SPC Law.
In addition, the Special Measures Law on Credit Obligation Management and Recovery Business (Servicer Law) was enforced to enhance the efficiency and transparency of loan servicing operations, whose importance had grown with the increase in securitized debt products. The Securities Investment Trust Law was also revised in 1998 to provide for company investment trusts which were authorized to invest in securities, and a registration system for real estate investment advisors was introduced in 2000 to provide further transparency and encourage heightened competency among these advisors, who would play an increasingly important role in future real estate securitization structures.
Investment Trusts and Investment Corporations Law
It was not until the revisions to and enactment of the Investment Trusts and Investment Corporations Law (ITIL) in November 2000 that the legal framework pertaining to real estate securitization was fully in place. The ITIL, which was based on earlier revisions to the Securities Investment Trust Law, regulated management of real estate as an investment product, primarily by authorizing entities known as investment trusts and investment corporations to conduct such management. These entities, the latter of which is the far more common form among REITs in Japan (J-REITs), are permitted to manage real estate investment products, but are limited to conducting only this business. Investment trusts and investment corporations can be formed as either open-end or closed-funds, but the latter is also more common due to the high level of liquidity that can be attained through trading investment corporation shares on exchanges.
The ITIL also heightened disclosure requirements for investment corporations, forbid the hiring of any employees, required stricter corporate governance and facilitated their increased access to debt through relaxed borrowing terms. Together, these measures lowered investment corporations’ exposure to operating risks, making them a safer securitization structure for investors. The ITIL enabled these entities to avoid taxation of any earnings they pay out to their investors as dividends, provided at least 90% of their taxable earnings are actually distributed.
A distinctive characteristic of the ITIL is its requirement that investment corporations outsource management of their owned assets to separate asset management companies. These asset managers perform such integral duties as making investment decisions for the investment corporation, acting as custodians for its assets, acting as agents for the distribution of revenue earned through the operation of its assets (primarily, rental revenues) and managing other practical affairs of the investment corporation such as the performance or outsourcing of property management and leasing activities. Assets managers are required to obtain approval from the Ministry of Land, Infrastructure, Transport and Tourism to act as a discretionary transaction agent based on the Building Lots and Buildings Transaction Law, separate approval from the Financial Services Agency (FSA) to act as an investment trust manager and must also hold a real estate brokerage license. Asset managers must also satisfy certain financial and personnel requirements and have a fiduciary duty to the investment corporation to act in the best interests of its investors and other stakeholders.
The establishment of an investment corporation involves the preparation and filing of bylaws and the selection of an executive officer and supervisory officers who agree on the price and amount of security offerings. There is a lower limit on paid-in capital of 100 million yen upon establishment. Investment corporations are not legally bound by ceilings on debt, though such limits are usually specified in the entity’s bylaws. In addition to issuances of equity, investment corporations may also float bonds but are required to outsource the management of these bonds.
The Birth of the J-REIT Market
In early 2001, the Tokyo Stock Exchange (TSE) established a J-REIT market that was distinct from other markets, and the first two J-REITs listed later that month. The TSE also established listing and de-listing requirements for J-REITs and additional disclosure requirements beyond those mandated by other laws to ensure that these entities concentrate on revenue-generating real estate assets, are of a sufficient size to be actively traded and maintain a high standard of transparency to attract the interest of investors and ensure their protection. For a J-REIT to list on the TSE, it must satisfy the following requirements:
|
Post-ITIL Legal Developments and the Financial Instruments and Exchange Law
Significant legislation during the years of securitization growth that followed the implementation of the ITIL included a revision to the Trust Business Law, which established a registration system for sellers of beneficiary interests in trust and expanded the types of businesses that can become trust companies (previously restricted to financial institutions) as well as the types of assets that can be entrusted (currently no restrictions). The Securities and Exchange Law was also revised in late 2004, designating investments conducted by TKs as “deemed negotiable securities,” and the 2005 enactment of the Limited Liability Partnership Law established the unincorporated limited liability partnership (LLP) structure.
During this period, the size of real estate securitization in Japan expanded considerably. However, calls for further reform in the Japanese financial system were beginning to be heard, demanding increased vitality through enhanced convenience, more efficient application to an ever expanding range of financial product types and additional investor protection through heightened disclosure and stronger governance, thereby encouraging more investment while also facilitating the internationalization of Japan’s capital markets.
Through these deliberations, the Financial Instruments and Exchange Law (FIEL) was enacted and came into effect in September 2007 under the objectives of (1) filling in gaps in user protection not covered by past legislation and (2) updating the then vertically oriented business laws to apply more consistently to financial instruments with similar economic functions. The FIEL classifies investment traders, advisors and managers of financial instruments into four types, each conducting different business activities and subject to different levels and scope of regulatory oversight. The FIEL’s jurisdiction includes regulation of investment management of collective investment schemes such as real estate securitization structures, and thus also applies to both public and privately placed real estate funds.
Also as a result of these deliberations, the Trust Law was revised in 2006 for the first time since its original enactment more than 80 years earlier and was enforced the following year. The chief effects of these revisions as they pertain to real estate securitization are the easing of restrictive regulations of the fiduciary duties of trusts that did not reflect the times and the establishment of new trust types such as limited liability trusts, self trusts and purpose trusts, which hold promise as simpler structures with steadier bankruptcy remote characteristics than earlier forms.
Recent Legal Developments
Over subsequent years, the size of the J-REIT market expanded significantly to become the fifth largest in the world based on market cap.
Nevertheless, the recent adverse economic environment has halted growth and
is forcing significant changes in Japan's real estate industry as well as changes in Japan's real estate industry.
Anticipating a wave of M&A activity as a means to revive a J-REIT market that has struggled in the wake of the financial crisis, the tax treatment of dividends paid out by J-REITs was reformed in 2009 to include those dividends paid out by a recently merged J-REIT in an absorption as expenses for the surviving entity. This was enacted in the hope of spurring consolidation of the industry to utilize scarcer capital more efficiently and has drawn the attention of domestic and global investors.
