In December 2008, the Japanese Diet established an administrative monetary penalty system by amending the Japanese Financial Instruments and Exchange Act (the equivalent of the Securities Act of 1933 and Securities Exchange Act of 1934). The amendment gave the Japanese Financial Services Agency (the equivalent of the U.S. Securities and Exchange Commission), for the first time in its history, an effective tool for the enforcement of Japan's tender offer and large share ownership reporting regulations. This article will provide a background of the Japanese tender offer and large share ownership reporting rules, describe the resulting changes in FSA enforcement strategy and provide suggestions foreign investors should consider before investing in Japanese public companies in light of the new rules.

Under the FIEA's tender offer rules, in certain situations, a purchase of voting equity securities (or securities convertible therefor) in a Japanese public company must be made in accordance with FIEA regulations. Those situations include (i) effecting an "off-market" acquisition (that is, a purchase of securities outside of a stock exchange) that brings the purchaser's holdings to one-third or more of the target company's voting shares and (ii) effecting "off-market" acquisitions from more than 10 sellers within 61 days that bring the purchaser to 5% or more of the target company's voting shares. Once the tender offer rules apply to an investor, that investor becomes subject to various statutory requirements, including requirements to make public announcement and register, treat all holders equally and hold the offer open for a specified period of time.

Under the large share ownership reporting regulations, whenever an investor effects an acquisition of voting equity securities (or securities convertible therefor) that brings it 5% or more of a Japanese public company's voting shares, that investor must electronically file a "large share ownership report" within five business days of the triggering acquisition (much like under the SEC's Schedule 13G rules, financial institutions are permitted to file special less-onerous reports on a less-frequent basis). Once the investor's ownership crosses that 5% threshold, an amendment must be filed each time the ownership changes by 1% or more, and each time a material change occurs with respect to descriptions in the report. Each report must disclose the name and percentage owned of the investor, the purpose of the investment and any material contracts with respect to the investment.

Though the rules described above were modeled after their U.S. counterparts, their enforcement has been significantly less stringent. Unlike the SEC, which has had broad enforcement mechanisms available to it, the FSA has largely been powerless from an enforcement standpoint. From its beginning, the FIEA provided for the imposition of criminal sanctions; however, these penalties were never fully utilized by regulators, largely due to the belief that criminal charges should be imposed only as a response to violations accompanied by serious culpability. In addition, because the FSA can't bring civil actions on behalf of aggrieved parties, no civil actions have been brought by the regulators in response to tender offer and reporting violations. The only practical remedy available to the FSA was to require investors who had submitted misleading tender offer documents or large share ownership reports to correct them.

In 2005, things started to change. A new penalty system was introduced, paving the way for monetary penalties in response to securities violations such as insider trading and market manipulation, but not the tender offer and large share ownership reporting rules. Then, in 2008, the FIEA was amended to expand the coverage of the penalty system to cover violations of these rules. The introduction of the new system came about as part of a collective effort by the Japanese government, stock exchanges and other authorities to improve market reliability by increasing the effectiveness of enforcement.

The new administrative monetary policy applies to tender offers and large share ownership reporting in different ways. With respect to the tender offer rules, each tender that either (i) fails to comply with required procedures (including public announcement and registration) or (ii) is accompanied by disclosure that includes a material misstatement or omission of fact, will be subject to a monetary penalty. The amount of the penalty can be surprisingly significant, as it is automatically set by statute at 25% of the market value of the securities purchased. Importantly, the severity of the violation is not taken into account when performing this calculation. So, if an acquirer makes a materially misleading statement in connection with a ¥1 million ($10,700) purchase, the penalty will be ¥250,000.

With respect to the large share ownership reporting rules, if an investor either (i) fails to file a large share ownership report (or an amendment to that report) when required or (ii) files a report (or amendment) that includes a material misstatement or omission, a penalty of 0.001% of the aggregate market value of the relevant securities will be assessed. Again, the severity of the violation is not taken into account.

To deter recurring violations, a 150% increase will apply if the investor was subject to another administrative penalty within the past five years.

Unlike more traditional sanctions, penalties imposed under the new rules are not accompanied by judicial review. Once a case is brought to the FSA, it independently imposes the applicable penalty and is given no discretion under the statute to consider the severity of the violation when determining whether to impose a penalty. Further, penalties are imposed on a strict liability basis. No proof of willfulness or negligence on the part of the investor is necessary for a penalty to be assessed so long as an objective violation has occurred. This sets the monetary penalty apart from criminal penalties, where willfulness must of course be proven.

In November, the first monetary penalty was imposed for a violation of the tender offer rules. The penalty was assessed on Ebanco Holdings Ltd., a British Virgin Islands investor, for failing to announce a tender offer for the securities of Sakha Diamond Corp., a Japanese public company. Though the purchase involved stock subscription rights, Ebanco's acquisition on an as-converted basis exceeded the one-third threshold described above. The penalty imposed upon Ebanco was ¥7.5 million, or 25% of the ¥30 million purchase of the stock subscription rights.

No penalties have been imposed to date for violations of the large share ownership reporting rules. That being the case, practitioners continue to view the new regime with concern, and they have begun observing the rules more cautiously than ever before. Notably, several large financial institutions have been submitting amendments to previously filed reports to correct prior misstatements.

Because there has only been one case to date where a monetary penalty was imposed under the new rules, additional study and analysis will be required. However, in the meantime, foreign investors should take into account the following considerations:

Consider whether the rules apply. If a transaction involves a significant investment in a Japanese company, carefully consider whether the tender offer or large share ownership reporting rules apply. Remember that some of the rules even apply to the securities of non-Japanese companies listed on a Japanese stock exchange. Hostile foreign acquirers should be even more careful, since the reputational damage from the imposition of a monetary penalty could end up being a critical impediment to the transaction.

Carefully review required disclosure. Foreign investors making tender offers for Japanese securities should carefully review with counsel any required disclosure for material misstatements and omissions. An accidental misstep could result in a penalty equal to 25% of the contemplated purchase price.

Review past filings. Investors active in Japanese securities acquisitions should review past filings for material misstatements and omissions and make sure material changes have been accounted for so as to correct errors before the imposition of a penalty. Penalties can be assessed for documents that have been filed within the last five years.

Consider voluntarily informing the FSA of past transgressions. If a failure to file a large share ownership report is discovered, consider bringing that to the attention of the FSA. While turning yourself in may increase the likelihood of a monetary penalty, the new rules decrease the penalty for a self-reporter by one-half.

Ari Lanin is a partner at Gibson, Dunn & Crutcher LLP and a member of the firm's mergers and acquisitions, capital markets and securities and corporate governance practice groups. Makoto Sakai is a visiting attorney at Gibson Dunn and practices with the firm's corporate transactions department.